The comparison between funds that track an index and funds that select holdings has been studied extensively over decades. The findings are reasonably consistent.
This summarises what the research reports. It is not a recommendation, and decisions about anybody's own money belong with a regulated adviser.
The core finding
Studies tracking active fund performance against relevant benchmarks over long periods consistently find that a majority underperform after costs.
The proportion underperforming rises with the time period examined, so that over ten or fifteen years the majority is substantial.
This has been reproduced across markets, asset classes and time periods by a number of independent analyses, which is what makes it a robust finding rather than a single result.
Why it happens
The explanation is largely arithmetic rather than a judgement about skill.
All investors collectively hold the market, so collectively they earn the market return before costs.
Which means that after costs, the average actively managed pound must underperform the average passively managed pound, since active management costs more.
This argument was set out formally decades ago and does not depend on any claim about manager ability.
Skill exists and is not the issue. The issue is that it must exceed the cost differential to produce a net benefit, and on average it does not.
The persistence question
Which addresses whether past outperformance predicts future outperformance.
Studies examining whether top-performing funds remain top-performing generally find limited persistence, with performance rankings shuffling substantially over subsequent periods.
Which means selecting a fund on its past record is a weaker method than the marketing suggests.
Some persistence has been found in the worst performers, who tend to continue underperforming, frequently because of high costs.
What the finding does not say
Where it is commonly overstated.
It does not say active management never works. Some managers do outperform over long periods, and identifying them in advance is the difficulty.
It does not say index tracking is risk-free. A tracker follows its index down as well as up, and concentration within an index is a real consideration.
It does not address asset allocation, which research generally finds explains a large share of portfolio outcomes and which is a separate question from fund selection.
And it says nothing about whether any particular approach suits any particular person, which depends on circumstances the research does not consider.
The tracking difference
A practical measure worth knowing.
An index fund does not exactly match its index, because of costs and the mechanics of holding the constituents.
The gap is reported as tracking difference or tracking error, and comparing it between funds tracking the same index is a straightforward measure of execution quality.
Which means not all trackers of the same index are equivalent, and the differences are small and measurable.
What an index actually is
Worth understanding since it is frequently treated as neutral.
An index is constructed according to rules — which securities are included, how they are weighted, how frequently it rebalances.
Those rules are decisions, made by a provider, and different indices covering nominally the same market can behave quite differently.
Market-capitalisation weighting means larger holdings dominate, which produces concentration when a few holdings become very large.
Which means tracking an index is not an absence of choices so much as delegation of them to the index provider.
The direction of the industry
Worth noting as context.
Flows into passive products have been substantial over the last two decades, and fee levels across the industry have fallen considerably as a result.
Which means the cost advantage that drove the finding has narrowed in some categories, and active funds have become cheaper in response to competition.
Some commentators have raised questions about the effects of very large passive ownership on corporate governance and price discovery, which is an active area of debate rather than a settled matter.
What the research does not settle
Worth being explicit since the finding is frequently extended too far.
It compares fund performance against benchmarks. It does not address whether anybody should be invested at all, in what proportion, or over what timescale.
Those questions depend on circumstances, obligations and risk tolerance, and no aggregate study addresses them.
Which means the evidence is useful for a narrow question — how to hold a given exposure — and silent on the larger ones that matter more to any individual.
Those larger questions are precisely where regulated advice earns its cost.
The survivorship adjustment
A methodological point that strengthens the finding.
Funds that perform poorly are frequently closed or merged, which removes them from the population being measured.
Comparisons that ignore this overstate average active performance, because the worst results have disappeared from the sample.
Studies correcting for survivorship find the proportion of active funds underperforming is higher than uncorrected comparisons suggest.
Which is worth knowing when reading any performance comparison, since the correction is not universally applied.