Active and passive management: what the fee buys

An active fund promises a result better than the market. A passive one promises the market's result minus a small fee.

Arithmetic that does not depend on skill

All market participants together own the whole market, so their average result before costs equals the market's. After costs it is lower by exactly those costs.

It follows that active management on average loses to passive by the difference in fees. That is not an assessment of managers' competence but an accounting identity.

Why past results mislead

Out of a large number of funds, some will show a good result by chance. Selecting a fund on past returns means selecting luck along with skill, and luck does not repeat.

Besides, unsuccessful funds that closed disappear from the statistics, and the average result of the survivors looks better than reality — see Survivorship bias: why success statistics mislead.

When active management makes sense

In narrow, under-researched segments where an informational edge is attainable. And where no index exists at all.

What to choose

A passive approach as the base — The index approach: buying the whole market. Active decisions for the part of a portfolio whose loss you could explain to yourself as tuition.

Related: Tracking error: how far a fund trails its index.