The superiority of index funds over active portfolio management

The renowned economist and Nobel Prize winner William Sharpe has impressively demonstrated in his groundbreaking work that the average result of active portfolio manager essentially corresponds to the success of the underlying index – i.e. the so-called reference standard or the “benchmark” – minus the average costs incurred in the management of thefunds accrue. This realization forms the basis for understanding the performance of active and passive investment strategies.

The zero-sum game of the active fund managers

If a fund manager overweights a particular stock compared to the index, another manager must underweight that stock. The totality of all deviations is thus evened out, so that the active management in its sum represents a zero-sum game. This means that for every fund manager who achieves added value through clever selection, there is another one whoto accept losses to the same extent. On average, active fund managers therefore only achieve the return on the index. However, since each fund is actively managed, management, analysis and transaction costs are incurred, the actual return on active funds is always below the index return – at exactly these costs.

Costs as a key disadvantage of active management

Passive investors investing in index funds also achieve the return on the benchmark, but only have to pay very low fees. These costs are usually significantly lower than the fees incurred in actively managed funds. For this reason, index funds perform better overall than classic investment funds, which are actively managed. The difference inThe costs are by no means minor: Kenneth French found that between 1980 and 2006, US investors paid an average of 0.67% annually for the search for over-returns. If the present value of these charges is calculated, the economic costs of active portfolio management are roughly 10% of the total market capitalization.make out. This means that around a tenth of the total economic output is spent on obtaining information and selecting investment projects.

Empirical evidence of the superiority of index funds

Numerous empirical studies confirm that the majority of fund managers are not benchmarking their benchmark. The longer the investment period considered, the more likely it is that an actively managed fund will underperform under the index. Christopher Philips and his colleagues have shown that with increasing investment time, the probability of aUnderperformance continues to rise and is almost certain in the long term. For private investors who cannot select particularly capable fund managers, an index fund with low management fees is the better alternative.

The illusion of overperformance and the survivorship bias

Despite these facts, active fund managers are always able to recruit new funds from investors. On the one hand, this is due to the fact that individual funds actually achieve exceptionally good results. On the other hand, the entire fund industry is influenced by a systematic distortion that makes active managers appear better than they actually are. Because when evaluating theFunds are usually only considered those who have “survived”; The yields of poor and already closed funds are not taken into account. This so-called survivorship bias means that the average performance of active funds is overestimated. Serious market data providers therefore also keep historical data from no longer existing funds in order to create a more realisticto convey image.

The role of active management for market efficiency

The question arises as to whether active management still has a right to exist at all. If only passive investments exist and no one analyzes the fundamentals of companies anymore, the capital market would no longer be efficient. Despite all the criticism of active portfolio management, its importance cannot be denied completely. With increasing spread ofIndex funds could turn the pendulum back into active management from a certain point, since more inefficiencies could then arise in the market again.

Opportunities for active management in niche markets

Active portfolio managers can achieve added value, especially when they are active in markets where there is no intense competition. This applies above all to smaller or less respected markets, so-called niche markets. An example of this is the Canadian stock market, which is significantly less competitive than the US market, although both markets are in the sameTime zone and messages are published in the same language. Even if investment strategies require flexible adjustments, active managers can be useful. For this reason, institutional investors often set up special funds that are managed according to their individual specifications.

Index fund as preferred choice for private investors

In summary, index funds are the superior choice for most private investors. They offer broad diversification, low costs and a higher long-term probability of achieving the market yield. Active management can be useful in certain market segments or under special conditions, but remains for the massesthe investor usually the less attractive option.