The Active Management Paradox: Why Skill Improvements Haven't Translated to Better Returns
"No army can withstand the strength of an idea whose time has come." — Victor Hugo
The Debate Continues
My July 23, 2025 Morningstar article, “If Active Investing Is the Loser’s Game, What’s the Winner’s Game?” examining active versus passive investing sparked a passionate response from Jeff Joseph, “Active vs. Passive Investing and Anti-Intellectualism,” who attempted to poke holes in the case for passive investing. His critique provides an excellent opportunity to examine the mathematical realities and empirical evidence that define modern portfolio management.
The Mathematics Matter More Than the Marketing
Joseph argues that "exactly 50% of all investors must outperform any given average" — but this reveals a fundamental misunderstanding of how markets actually work. The reality is more nuanced and far less favorable to active management.
The Gross vs. Net Returns Problem
While it's true that for every dollar of outperformance there must be a dollar of underperformance before expenses, investors don't earn gross returns — they earn net returns (after all expenses, not just expense ratios, but all transactions costs, including market impact costs) . Since active managers charge significantly higher fees than passive funds, and they have higher turnover, they collectively deliver lower net returns to investors. This isn't theory; it's arithmetic.
The Evidence is Overwhelming
The 2024 SPIVA scorecard revealed that 94% of active domestic funds underperformed the S&P 1500 over 20 years. On a risk-adjusted basis, the failure rate exceeded 97%. These aren't close calls — they represent systematic underperformance across the industry.
The "Price Discovery" Red Herring
Joseph suggests that passive investing creates price distortions that should benefit active managers. If this were true, we'd expect to see improving active management performance as passive investing has grown. Instead, the opposite has occurred.
In 1998, Charles Ellis wrote what has become an investment classic, Winning the Loser’s Game. Ellis presented compelling evidence that led him to conclude that active management was a “loser’s game.” At the time, even before considering taxes, only about 20 percent of actively managed funds were outperforming on a risk-adjusted basis. Just 12 years later, Eugene Fama and Ken French’s 2010 paper, “Luck versus Skill in the Cross-Section of Mutual Fund Returns” found that only managers in the 98th and 99th percentiles showed statistically significant skill — essentially the same as random chance would predict. Their finding closely matches the findings of the 2016 study “Mutual Fund Performance through a Five-Factor Lens,” by Philipp Meyer-Brauns. Meyer-Brauns found an average negative monthly alpha of -0.06 percent (with a t-stat of 2.3). He also found that about 2.4 percent of the funds had alpha t-stats of 2 or greater, which is slightly fewer than what we would expect by chance (2.9 percent). Meyer-Brauns extended his work in his March 2017 paper “Luck vs. Skill Across Different Fund Categories.” He examined four separate categories of U.S. equity mutual funds (large cap value, large cap growth, small cap value, and small cap growth) over the period from January 2000 through June 2016. He found that the best performing funds performed no better than would be expected by chance alone in a zero-alpha world. For example, the by-chance distributions indicate that if all funds could cover their costs, slightly more than 2 percent should be expected to have alpha t-stats larger than 2. Looking at the actual distributions across fund categories, he found that in two of the four categories, large cap value and large cap growth, not a single fund had an alpha t-stat above 2. For the two other categories, small cap value (1.8 percent) and small cap growth (1.1 percent), the percentage was lower than would be expected by chance.
The Active Share Disappointment
One of the most compelling narratives in active management is that funds with high "Active Share" — those that deviate most from their benchmarks — should outperform. The initial 2009 research by Cremers and Petajisto seemed to support this idea, giving active management advocates renewed hope.
The Follow-Up Studies Tell a Different Story
Multiple subsequent studies have systematically dismantled the Active Share thesis:
AQR's Analysis: Using the same database as the original study, the authors of “Deactivating Active Share,” found that active share had no predictive power for fund returns when properly controlling for benchmarks.
BlackRock's Out-of-Sample Test: Using post-2009 data, their study, “Estimating Time-Varying Factor Exposures,” showed active share was negatively correlated (-0.75) with fund returns after controlling for other factors.
International Evidence: Studies of Canadian (Active Share Doesn’t Live Up to the Hype) and South African funds (Defining Activeness: Active Share, Risk Share & Factor Share) confirmed that active share's failure wasn't limited to U.S. markets.
Vanguard's Comprehensive Review: Their 15-year analysis (2004-2018) “The Urban Legends of Active Share.” found that low-cost, low-active-share funds actually outperformed high active share funds.
Even the Original Author's Updated Data
Most tellingly, when I contacted Cremers for post-2002 performance data, he provided me with the table below, which shows the results over that timeframe for the active share quintile portfolios (the first quintile is the lowest active share).
Quintile 1 2 3 4 5
Alpha -1.05 -1.11 -1.43 -0.68 -0.50
T-stat (4.4) (4.2) (5.4) (2.0) (1.1)
The strategy that seemed promising in the original study period had "gone with the wind" as markets became more efficient.
The Paradox of Skill
Perhaps the most fascinating finding comes from Pastor, Stambaugh, and Taylor's research, “Scale and Skill in Active Management,” which discovered that fund manager skill has actually improved over time — from -5 basis points per month in 1979 to +13 basis points per month in 2011. Yet this skill improvement hasn't translated to better performance for investors.
Why Skill Doesn't Equal Success
The answer lies in competition. As the active management industry has grown larger and more competitive, it takes more skill just to keep pace. This creates what researchers call "the paradox of skill" — as overall skill levels rise, luck can become more important in determining outcomes. That makes it harder to distinguish results that were based on skill or were they based on random luck.
The Real Winner's Game
The evidence points to a clear conclusion: for most investors, the winner's game is not trying to pick the few active managers who might outperform, but rather accepting market returns through low-cost, diversified systematic funds.
The Math is Simple
97% of active funds underperformed on a risk-adjusted basis over 20 years.
High active share doesn't predict outperformance.
Even improving manager skill hasn't overcome competitive pressures.
Total expenses (including bid/offer spreads and market impact costs), not just management fees, matter more than most investors realize.
Following the Money
It's worth noting that even as this evidence has mounted, we continue to hear annual predictions that "this year will be different" or that "it's a stock picker's market." As Upton Sinclair observed, "It is difficult to get a man to understand something, when his salary depends on his not understanding it."
The flow of investor dollars tells the real story: passive funds absorbed $244 billion while active funds saw outflows of $257 billion in recent periods. Investors are voting with their wallets, choosing the mathematical certainty of capturing market returns over the lottery ticket of trying to beat them.
Conclusion: Embracing the Winner's Game
The winner's game isn't about finding the few needles in the haystack of active management. It's about accepting that markets are remarkably efficient (though not perfectly so) at incorporating information into prices, and that your best strategy is to own a piece of that efficiency rather than trying to outsmart it.
In a world where 97% of active managers fail to beat their benchmarks on a risk-adjusted basis over meaningful time periods, the prudent choice becomes clear. The winner's game is the one where you don't have to win at all — you simply participate in the wealth creation of global capitalism through low-cost, diversified index funds. AQR’s founder Cliff Asness put it this way: “I am fond of saying that active management is an inherently arrogant act. Because the average can’t beat the average by investing actively (not market cap indexed) rather you have to assume you are decently better than average. It’s an arrogance, to nobody’s shock who knows me.”
The strength of this idea may indeed be unstoppable, just as Victor Hugo predicted.
Larry Swedroe is the author or co-author of 18 books on investing, including his latest Enrich Your Future. He is also a consultant to RIAs as an educator on investment strategies.
Very good article — I agree with most of your conclusions.
However, I think there are two conceptual issues worth clarifying:
1. The mean doesn’t imply that half of investors must be below it. A distribution can be very skewed — many slightly below average and a few far above. In fact, that’s exactly how the distribution of individual stock returns looks: many slightly underperform the average, and a few massively outperform it. Why should the distribution of fund returns (baskets of those same stocks) be any different?
2. It’s also not strictly correct to say that before costs, what one active investor outperforms, another must underperform. Active management as a whole is not necessarily a zero-sum game, as Sharpe’s arithmetic suggested. In principle, the active segment could collectively outperform the index if it allocates capital more efficiently (taking advantage of corporate events and net fund flows). I just wrote about this, summarizing Pedersen’s response and reinterpreting the Gotrocks family story: https://sudapollismo.substack.com/p/gestion-activa-no-suma-cero
"The Evidence is Overwhelming. The 2024 SPIVA scorecard revealed that 94% of active domestic funds underperformed the S&P 1500 over 20 years." > This point has two holes in it. First, it assumes that investment performance should be measured by return, instead of how everyone actually invests which is return as a function of the investor's risk tolerance. Return should be measured as 'return per unit of risk' not just 'return.' Risk matters. Secondly, you pick mutual fund managers. These funds manage risk, you choose not recognize that. And what about the individual investors, both professional and retail, who successfully manage/trade their own accounts. Everyone in our business knows many successful traders who quietly beat the markets. Just because you don't know or can't account for these successful traders, managers etc. doesn't mean they don't exist.
The studies you reference from AQR, BlackRock and Vanguard. All the studies you mention are taken from one sample - the single best performing stock market in the history of the world during one of the best time periods for investors that has ever existed. Please research other markets, during times when there's not a huge upward price bias and let me know how the results come out. (Don't forget to measure risk. People care about volatility in real life.)
Statements like this: "97% of active funds underperformed on a risk-adjusted basis over 20 years." are pure cherry picking. You're looking at one market over a few years. Who cares? How about the next 20 years? How has the market performed over 20 year periods when the starting valuation is in the 95th percentile of all market history? Want to passively hold stocks, with no plan to sell, no matter what? Be my guest. I choose to actively seek undervalued assets and manage risk.