Active versus passive: The one debate the numbers settle

Two ways of investing have clashed for fifty years. Picking the winners, or buying the whole market.

Active management looks for the best shares. Passive management buys the entire index, and does nothing else.

It is one of the rare debates in finance that numbers can settle. And they settle it clearly.

Let's start with simple arithmetic. All investors together are the market. Before fees, they therefore make, on average, the market return.

Passive investors make the market, minus tiny fees. So active investors, together, also make the market, but minus heavier fees.

On average, active management therefore does worse than the index. The economist William Sharpe wrote it in nineteen ninety-one.

The idea has a father: John Bogle. In nineteen seventy-six, he launched the first index fund open to the general public.

People mocked it. They called it Bogle's folly. It raised far less than expected.

Fifty years later, index funds manage trillions of dollars.

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In two thousand seven, Warren Buffett made a bet. A simple index fund would beat, over ten years, hedge funds chosen by a professional.

A manager took up the challenge and chose five funds of hedge funds. The bet ran from two thousand eight to two thousand seventeen.

After ten years, the index had made about eight and a half per cent a year. The best of the five funds, six and a half. The worst, almost nothing.

Buffett won easily. The winnings went to a charity.

A bet is an anecdote. For proof, there is the SPIVA report, published every year for more than twenty years.

It counts, market by market, how many active funds do worse than their index.

Over one year, it is often more than half. Over fifteen years, in the United States, it is nearly nine in ten.

And the rare winners change from one period to the next. Having beaten the index yesterday says almost nothing about tomorrow.

The main reason is fees. Say ten thousand euros, a six per cent gross return a year, for thirty years.

With zero point two per cent of fees, you end up with about fifty-four thousand euros. With one point eight, about thirty-four thousand.

Nearly twenty thousand euros apart, gone in fees and lost interest. For the same risk.

Passive has its limits, though. It buys without thinking, even what is too expensive. And someone has to set the prices.

But for a saver, the lesson is clear: before hoping to beat the market, make sure you are not paying to do worse.