Can Active Fund Managers Outperform Index Funds Before Fees?

Investors often wonder whether active fund managers can consistently outperform index funds, particularly before the fees are taken into account. The answer is nuanced and varies widely depending on the specific fund manager and the market conditions. This article delves into the historical performance data of fund managers and provides insights based on economic theories, with special focus on the impact of fees and the work of renowned economist William F. Sharpe.

Data Analysis of Fund Performance

When reviewing equity fund categories such as Large Cap Blend Managers, SP500 Small Cap Blend, and Russell 2000 over a 10 to 15-year period, it has been observed that approximately half of the managers outperform their respective indexes before fees are applied. However, when fees are factored in, the number of outperformers dwindles to around a quarter or a third.

This reduction is partially explained by selection bias. On one hand, the current dataset does not include underperforming managers and funds that were unsuccessful in lasting 15 years. On the other hand, it reflects fees that were higher than today's average, which means that many managers in earlier years were operating with higher expense ratios.

Investor Selection Bias and Future Performance

Another important factor is the persistence of performance in the fund management industry. A study indicates that high-performing managers with a good track record are more likely to continue outperforming in the future compared to underperforming managers. Consequently, it might sometimes be rational for investors to choose actively managed open-end funds priced at Net Asset Value (NAV) over passively managed ones.

The Arithmetic of Active Management

A key insight comes from the academic work of Nobel Laureate William F. Sharpe, who published 'The Arithmetic of Active Management' in 1991. Sharpe posits that, in the absence of fees, the returns on both actively managed and passively managed funds will be identical. This is underpinned by the mathematical laws of addition, subtraction, multiplication, and division.

Specifically, Sharpe asserts that:

Before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar. After costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.

These assertions hold for any time period and depend solely on the aforementioned mathematical principles, without requiring additional assumptions.

Conclusion and Implications

While it is theoretically possible for active fund managers to outperform index funds before fees, historical data suggests that this is more rare than one might initially assume. Investors should carefully consider the role of fees, the persistence of performance, and the mathematical underpinnings of fund returns before making investment decisions.

Understanding these factors can help investors make more informed choices and avoid the pitfalls of overpaying for underperforming funds or missing out on the potential benefits of passive management.