In the ever-evolving landscape of personal finance and investment management, one principle has emerged with compelling clarity over recent decades: for the overwhelming majority of investors, ‘active’ management, once considered the gold standard of portfolio construction, has been eclipsed by the more efficient, cost-effective strategy of passive investing via low-cost, globally diversified index funds.
While active managers claim to outperform markets by identifying undervalued securities and timing the market, the empirical data suggest otherwise. With modern financial technology, improved access to markets, and decades of academic research now available to the general public, the historical advantages once enjoyed by active managers have been significantly eroded, calling into question the justification for their higher fees.
The Inefficiency of Active Management
Active portfolio management refers to the practice of employing human expertise to select securities and time entry and exit points in the hope of achieving market-beating returns. This approach entails significantly higher costs in the form of management fees, trading costs, and tax inefficiencies.
Multiple studies, including the widely cited SPIVA (S&P Indices Versus Active) Scorecards, consistently show that the vast majority of active managers fail to outperform their respective benchmarks over extended time horizons. For instance, according to the 2023 SPIVA US Year-End Scorecard, over 85% of large-cap US equity fund managers underperformed the S&P500 over a ten-year period. In the Canadian context, a similar pattern prevails, with most active Canadian equity managers failing to beat the S&P/TSX Composite Index over the long run.
These results are not anomalous. Rather, they reflect the structural inefficiencies of active management. Markets are generally efficient in the sense that prices reflect available information, a phenomenon well-supported by Eugene Fama’s Efficient Market Hypotheses (EMH). In such an environment, consistent performance is not only rare, but also largely attributable to luck rather than skill. Accordingly, paying premium fees for an active strategy is often tantamount to subsidizing the pursuit of randomness.
The Hidden Cost of Active Fees
One of the most frequently overlooked variables in investment performance is the corrosive impact of fees over time. While a 1% or 2% management fee may appear negligible in the short-term, its long-term effects are profound.
Consider a hypothetical investor with $500,000 invested over 30 years earning an average annual return of 6%. A portfolio managed with a 2% annual fee would grow to approximately $1.37 million, while a comparable index fund portfolio with a 0.20% fee would grow to roughly $2.42 million. The difference – over $1 million – is due solely to fees, not investment returns. In a legal context, one could reasonably argue that the persistent recommendation of high-fee active funds, when comparable low-cost solutions are readily available, raises questions of fiduciary responsibility.
Indexing: A Rational and Evidence-Based Approach
Passive investing through index funds offers a solution rooted in transparency, diversification, and cost-efficiency. An index fund seeks to replicate the performance of a market benchmark, such as the S&P500, MSCI World, or FTSE Global All Cap Index. These funds do not attempt to ‘beat’ the market; rather, they endeavor to ‘be’ the market.
This approach provides several advantages. First, costs are substantially lower. Many index funds and ETFs now charge management expense ratios (MERs) as low as 0.05% to 0.25%. Second, by owning a broad swath of the global economy, investors eliminate the risks associated with concentrated bets on specific companies, sectors, or geographies. Third, index funds tend to be more tax-efficient due to lower portfolio turnover.
Academic research overwhelmingly supports the efficacy of this approach. The foundational work of Nobel laureates such as William Sharpe and Eugene Fama has demonstrated that low-cost indexing is statistically more likely to yield superior net returns over time. As Sharpe famously concluded, ‘after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar’.
The Role of Technology in Democratizing Access
Thanks to technological innovation, what was once the exclusive domain of institutional investors is now accessible to the general public. Online brokerages and robo-advisors offer globally diversified portfolios constructed from low-cost index ETFs with automated rebalancing and tax-loss harvesting, all at a fraction of the cost of traditional advisory services.
Furthermore, fintech tools provide real-time visibility, educational resources, and software that empower investors to take greater control of their portfolios without incurring the prohibitive costs of legacy management models. This technological democratization of investing has leveled the playing field and exposed the inefficiencies and conflicts of interest that often plague the active management industry.
Legal and Ethical Considerations
From a fiduciary and legal standpoint, the continued promotion of expensive, underperforming active strategies must be viewed with scrutiny. Financial advisors and portfolio managers who are held to a fiduciary standard have a legal duty to act in the best interests of their clients. This includes the duty to recommend cost-effective investment options that align with a client’s risk profile and financial goals.
Given the overwhelming evidence in favour of low-cost index investing, failure to adequately disclose the underperformance and higher cost of active strategies could, in certain contexts, constitute a breach of fiduciary duty or failure to provide suitable advice under applicable securities regulations.
Conclusion
In the modern era of investing, the rationale for active management has become increasingly tenuous. While there may be limited circumstances in which active strategies are appropriate, such as institutional portfolios with unique mandates or high-net-worth clients seeking specific asset class exposure, the default strategy for most individual investors should be a globally diversified portfolio of low-cost index funds.
Investing need not be complicated, expensive, or speculative. The path to long-term wealth accumulation lies not in the pursuit of market-beating performance, but in harnessing the power of markets themselves; efficiently, broadly, and at minimal cost.