The debate over active versus passive investing has raged in the investment world since the 1970s. The core issue raised by both sides of the argument is whether actively managed funds, which apply a human element alongside analysis to construct an investment portfolio, can outperform passively managed funds, which construct an investment portfolio that simply mirrors a specific index with little or no human element. The core issue for investors is whether the higher fee paid for active management is worth it over the long term, if these funds cannot consistently outperform passive management.

Active vs. Passive Fees

According to a 2015 study on fees by Morningstar Inc. (NASDAQ: MORN), the average asset-weighted expense ratio across all funds has been declining since 2010. The average expense ratio was 0.76% in 2010, and it fell to 0.64% by 2014. In that time, 63% of the funds reduced their expense ratios, while 21% actually increased their costs. In 2014, the asset-weighted expense ratio for passive funds was 0.20%, compared to 0.79% for active funds. In active equity funds, the average expense ratio increased among mid- and small-cap funds, as well as sector and international equity funds.

Morningstar makes the case that investors are driving down expense ratios based on where they invest their money. Since 2006, 95% of all flows have moved toward the lowest-cost funds, with passive funds gaining a disproportionate share. Passive funds have received $1.90 trillion in new assets, compared with $1.13 trillion for active funds. In U.S. equity funds, passive funds gained $671 billion in assets, while active funds lost $731 billion. Low-cost fund market leader Vanguard Group has been the largest recipient of flows, having increased its market share of total assets from 15% in 2008 to 19.2% in 2014, which is more than double the share of its closest competitor, Fidelity Investments.

What About Performance?

To create as close to an apples-to-apples comparison as possible, Morningstar came out in 2015 with its Active/Passive Barometer, offering bias-free data to inform the debate. Instead of comparing active managers’ returns against an index, it compares them with a composite made up of relevant passive index funds, including exchange-traded funds (ETFs). This provides a more accurate comparison of net-of-fee performance of passive funds instead of an index that is not investable. The last report was published in June 2015, reporting returns through Dec. 31, 2014.

In comparing all equity fund categories, the report showed that only two groups of active managers had a success rate of better than 50% against passive funds over a one-year period. Actively managed U.S. small growth funds had a success rate of 51.4%, and diversified emerging markets were successful at a rate of 58.2%. Only 32.7% of U.S. large blend and 21.3% of large value funds outperformed their passively managed counterparts. Over a 10-year period, only U.S. mid-value funds managed to outperform with a success rate of 54.8%. The worst performers against passive funds were U.S. large growth at 16.9% and U.S. mid-blend at 13.7%. On an annualized total return basis, equity passive funds generated on average 0.65% higher returns over 10 years. U.S. mid-value, foreign large blend and diversified emerging markets were the only two categories to outperform passive funds.

Which Type Has Better Odds?

Overall, investors have substantially improved their odds of success by investing in low-cost funds. While the data shows that a percentage of actively managed funds outperform passively managed funds, the challenge for investors is choosing which actively managed fund is the best. Less than 25% of the best-performing actively managed funds are able to repeat their performance consistently. Depending on the fund category, investors have anywhere from a 55 to 84% chance of outperforming actively managed funds by investing in a passively managed fund.

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