Active or passive investing: ETFs versus fund managers

Basics8 min read · updated 7 September 2026 · 7 sources

Active or passive? This question lies behind almost every choice of fund. Passive funds such as ETFs track an index and cost little. Active funds try to beat the index through selection and timing, and charge higher fees for it. The research here is unusually clear: on average and over long periods, most active funds trail their benchmark index after costs. A simple calculation shows why this is almost inevitable.

What active and passive mean

A passive fund buys the securities of an index at their index weights and only changes them when the index changes. It does not try to beat the market, but to deliver the market as cheaply as possible. An active fund deliberately deviates: it overweights stocks it considers promising, avoids others or changes the split between equities and bonds. To do this it pays analysts and fund managers and trades more often.

The boundary is not entirely sharp. An ETF also rests on decisions: which index, which weighting, which countries? Factor ETFs, for example on value or momentum, follow fixed rules but deviate from the market portfolio (see Fama-French factors). The basic question remains: is it worth paying higher costs for deviating from the market?

The arithmetic of active management

In a short paper, Sharpe (1991) showed why active investors must lose on average. Divide all investors in a market into two groups: passive investors hold the market, active investors deviate from it. Together, both groups hold exactly the market. Before costs, the average return of the active investors must therefore equal the market return: what some earn in excess, others earn less. After costs, active investors fall behind on average, because they pay more for management and trading.

An example makes this tangible: a market returns 8% in one year. Half of the money is invested passively and earns 7.8% after 0.2% costs. The other half is active: some managers achieve 12%, others 4%, on average exactly 8% before costs. After all, together they hold what the passive investors do not hold, which is also the market. After 1.5% costs, active investors are left with 6.5% on average.

This statement needs no assumptions about markets, efficiency or talent. It applies to the average, not to every individual fund. A single fund manager can do better, but then another must do worse, and you do not know in advance who is who.

Costs in a worked example

Because cost differences repeat every year, they work through compound interest. In Germany, active funds often charge well over 1% a year in ongoing charges, and front-end loads may come on top; broad ETFs are often at 0.1% to 0.3%.

French (2008) estimated these costs for the entire US stock market: on average over the years 1980 to 2006, investors spent 0.67% of the aggregate market value every year searching for superior returns, on fees, trading costs and advice. By his calculation, a typical investor would have earned 0.67 percentage points a year more by investing passively.

What the data show

The regular SPIVA reports compare active funds with their benchmarks. For funds offered in Europe, according to SPIVA Europe (2025), over ten years 93% of equity funds and 79% of bond funds lagged their index, as a fund-weighted average across all categories. Funds that were closed or merged during this period count as underperformers; otherwise the picture would look too rosy.

This problem is called survivorship bias: poor funds disappear from the databases, and the survivors look better than the fund industry as a whole actually was. Brown et al. (1992) show that this effect distorted almost all older performance studies, not only the average performance but also the ranking of managers. Using data that included all funds in every year, Malkiel (1995) found that equity funds fell short of their benchmark portfolios after costs and even before costs.

Are there consistently good managers?

Individual funds beat the market for years. The question is whether that is skill or luck, and whether you can identify the winners in advance. Carhart (1997) studied the persistence of fund returns without survivorship bias. Almost all of the apparent persistence could be explained by common factors such as momentum and by cost differences. One thing above all was persistent: the worst funds stayed bad. He found no evidence of systematically superior managers.

Fama and French (2010) reach a similar conclusion: the aggregate portfolio of active US equity funds is very close to the market portfolio, but the high costs show up in full as lower returns for investors. According to their simulations, only a few funds earn enough to cover their costs; genuine skill before costs appears at most in the extreme tails of the distribution.

Checking active funds

If you are considering an active fund, you can ask a few questions that data can answer:

• Which index is the fair comparison? A fund for European small caps must be measured against a small-cap index, not against the DAX.
• How much deviation is there at all? A low tracking error combined with high costs points to an “index fund at an active price”.
• Where does the excess return come from? A factor regression or style analysis shows whether it stems from factors that can be replicated cheaply, such as value or small caps.
• How reliable is the alpha? Even a good Sharpe ratio over a few years is statistically uncertain; many funds on offer mean many lucky winners.

Passive does not mean planless

Investing passively still involves important decisions: equity allocation, country allocation, the share of emerging markets, rebalancing rules and how to deal with crises. These decisions determine the outcome far more than the choice between two similar index funds. The essence of passive investing is not doing nothing, but forgoing forecasts about individual securities and timing, and the costs such forecasts incur.

Limitations and objections

Passive investing raises questions of its own. If more and more money is invested passively, who ensures that prices are right? Sharpe's arithmetic holds regardless; only the remaining competition among active investors gets tougher. Capitalisation-weighted indices also buy more of what has already become expensive. That is why some investors opt for equal weighting or factors. And ETFs, too, show small deviations from their index because of costs and taxes within the fund (see ETF basics).

How Portfolio Lab calculates it

Portfolio Lab offers several tools for comparison. Under Assets, the fund comparison compares trailing returns from one month to 15 years as of a common reference date, including ranks and quartiles. In the Backtest with a benchmark, you see alpha, beta, tracking error and information ratio. Style analysis and Factors break down a fund's return. How these metrics are calculated is described in the metrics methodology.

This article explains a method; it is not investment or tax advice. Worked examples are simplified and rounded. All terms in the glossary.