David Chen opened his new employer’s benefits packet in March 2009. The market had just collapsed. Two mutual fund options sat in front of him for his retirement account: a large-cap growth fund managed by a team with impressive credentials, and a basic S&P 500 index fund charging 0.04% annually.
The growth fund had beaten the market by 2.1% the previous year. It charged 0.89%.
He chose the index fund.
The Math Behind Manager Underperformance
The case for active management seems intuitive. Skilled professionals analyzing companies, meeting with executives, and timing entry points should outperform a strategy that simply owns everything. But the data tells a different story.
According to SPIVA scorecards tracking performance over the 15-year period ending in 2023, roughly 88% of actively managed U.S. large-cap funds underperformed the S&P 500. For small-cap managers, the figure reached 93%. Mid-cap active funds fared slightly better at 85% underperformance, though “slightly better” still means overwhelming failure relative to the benchmark.
This is not a temporary phenomenon. Extend the window to 20 years, and the underperformance persists. Shorten it to 10 years, same pattern. The consistency across time periods suggests something structural rather than cyclical.
The explanation lies in costs, not capability.
| Cost Component | Active Fund (Typical) | Index Fund (Typical) | Annual Difference |
|---|---|---|---|
| Expense Ratio | 0.65% – 1.10% | 0.03% – 0.15% | 0.50% – 1.07% |
| Trading Costs | 0.20% – 0.50% | <0.05% | 0.15% – 0.45% |
| Tax Drag (Taxable Accounts) | 1.00% – 2.00% | 0.10% – 0.30% | 0.70% – 1.70% |
| Total Annual Headwind | 1.85% – 3.60% | 0.13% – 0.50% | 1.35% – 3.25% |
Active managers do not need to fail at stock selection for their funds to underperform. They simply need to be average at it. Because once you subtract roughly 1.5% to 2.5% in typical annual frictions from average market returns, you fall behind an index fund capturing those same returns for 0.10%.
The active manager must be correct more often, by a wider margin, just to break even.
Why Past Performance Creates False Confidence
Sarah Mitchell saw her colleague’s 401(k) statement in 2014. His actively managed fund had returned 19.8% that year while her S&P 500 index fund returned 13.7%. She felt, distinctly, like she had missed something.
By 2016, she had moved 60% of her retirement balance into that same active fund. The manager had a 10-year track record. The fund’s prospectus highlighted its discipline, its research depth, its patient approach.
What Sarah didn’t see was the selection bias embedded in that performance history. Funds that fail get merged into better-performing siblings or shut down entirely. The track records that survive are, by definition, the ones that succeeded. You’re not comparing an active fund to an index fund. You’re comparing the winners that are still around to everything.
Fund companies managed 8,000+ mutual funds in 2000. By 2020, roughly 4,200 of those had disappeared. Their performance didn’t average into the data. It vanished.
The funds you’re evaluating today are pre-screened survivors.
Even among the survivors, performance persistence remains elusive. Morningstar tracked funds in the top performance quartile over five-year periods and measured how many remained in the top quartile for the next five years. The figure hovered around 23%—barely better than random chance would predict.
A manager who outperforms for three years has roughly the same probability of outperforming over the next three years as a fund chosen randomly from the same category.
The Tax Efficiency No One Mentions
In tax-deferred accounts, the cost difference between active and passive strategies is meaningful. In taxable brokerage accounts, it becomes severe.
Active funds generate capital gains distributions as managers trade positions. Even if you never sell a single share of the fund itself, you owe taxes on gains the fund realized internally. Index funds, holding positions for years and trading only when index constituents change, distribute minimal gains.
Consider two investors, both with $100,000 in a taxable account, earning identical 8% annual pre-tax returns over 20 years. One holds an actively managed fund distributing 6% of its value annually as taxable gains. The other holds an index fund distributing 0.5%.
At a 20% capital gains rate, the active fund investor pays roughly $1,200 annually in taxes early on, rising as the balance compounds. The index investor pays about $100. That 1.2% annual tax drag on the active fund versus 0.1% on the index creates a 1.1 percentage point difference in net returns.
After 20 years, the active fund grows to approximately $370,000. The index fund reaches $455,000.
Same underlying return. Different structure. $85,000 difference in after-tax wealth.
You’re not planning for the average. You’re planning for your specific tax situation and sequence of events.
When Active Management Actually Makes Sense
The argument against active funds is not absolute. Certain market segments and conditions create genuine opportunities.
Emerging markets, where information asymmetries are larger and pricing inefficiencies more common, show better active manager success rates. Small-cap value stocks, less analyzed and less liquid than large-cap growth, occasionally reward skilled research. Niche strategies focused on specific sectors or themes may access opportunities unavailable through broad indexing.
The problem is identifying which active managers will capture those opportunities before they do it.
If you cannot reliably predict which 12% of active managers will outperform over the next 15 years—and the data suggests you cannot—the lower-cost, tax-efficient option becomes the default rational choice. Not because it’s exciting. Because the math supports it.
How the Story Ended for David and Sarah
David Chen’s index fund choice in 2009, with the market near its bottom, compounded at roughly 13.4% annually through 2024. His initial contributions, plus consistent additions, grew his retirement account to approximately $340,000.
Sarah Mitchell’s blended approach—60% in the actively managed fund she switched to in 2016, 40% remaining in her index fund—compounded at roughly 11.1% annually over the same period. Her account reached about $285,000. The active fund she chose underperformed its benchmark by an average of 1.8% annually after its strong years ended.
She didn’t make a reckless decision. She responded to evidence that seemed compelling. The fund had a credible story, a solid track record, and returns that looked superior. The issue wasn’t her judgment. It was the structural reality embedded in cost differences, tax drag, and the difficulty of sustaining outperformance.
By 2024, that $55,000 difference represented roughly 16% less retirement capital for essentially the same risk exposure and time horizon.
The Durable Advantage Lives in the Structure
Most financial debates center on prediction: which stocks, which sectors, which managers. The active-versus-passive question sidesteps prediction entirely.
You don’t need to forecast which companies will outperform. You don’t need to time when growth will outpace value or when small caps will surge. You own everything, proportionally, and let the market’s aggregate growth do the work. The cost of that approach has fallen to nearly zero.
Active management, by contrast, requires multiple correct predictions compounding together: identifying skilled managers before they outperform, trusting that skill will persist, accepting higher costs and tax burdens, and believing the excess return will exceed those frictions.
One strategy bets on the market’s long-term growth. The other bets on your ability to identify and access skill that data suggests is rare, inconsistent, and expensive.
The evidence doesn’t forbid active management. It simply clarifies the burden of proof required to justify it. For most investors, across most time horizons, that burden remains unmet. Not because markets are perfectly efficient, but because the cumulative weight of costs, taxes, and selection difficulty creates a structural disadvantage that few managers overcome.
What feels like a choice between ambition and mediocrity is actually a choice between two return streams separated by predictable, quantifiable frictions. One of those streams compounds in your favor. The other compounds against you.
The advantage isn’t hidden. It’s just quiet.
