As we typically do each quarter, today we revisit the debate between active and passive management by looking at how passive indices have fared across several different markets.
As we typically do each quarter, today we revisit the debate between active and passive management by looking at how passive indices have fared across several different markets – US large cap equity, US small cap equity, international developed equity, emerging market equity, and US fixed income – over both the short- and long-term.
This year has provided us with a good opportunity to evaluate active vs passive management as we experienced a geopolitical driven drawdown and subsequent recovery which active managers could have potentially positioned for. One of the arguments in favor of active management is that active managers will outperform in down markets.
The key determinant of which style, active or passive, is superior is market efficiency. Market efficiency describes the degree to which asset prices quickly and rationally adjust to reflect new information. In highly efficient markets, new information is quickly incorporated into prices, and therefore it is not possible to consistently achieve above-average risk-adjusted returns in these markets. Therefore, due to their lower cost, investors are better off utilizing passive strategies in highly efficient markets. In less efficient markets, on the other hand, the opportunity exists for skilled active managers to outperform passive strategies, thereby adding value for clients.
The active vs. passive debate often focuses on large-cap U.S. equities, which is a natural starting point for the discussion – the large-cap U.S. equity market is composed of the most well-known companies in the world and represents a large portion of many retirement portfolios. However, if we stop there, we ignore what should be an obvious and fundamental element of the discussion – the various markets around the globe are unlikely to all be equally efficient. The very fact that U.S. large-cap companies are the most visible and researched firms in the world suggests that the U.S. large-cap equity market is likely to be more efficient than its less well-known counterparts! It is because of the variation in efficiency that the merits of active versus passive management should be evaluated on a market-by-market basis.
On the surface, the debate between active and passive may seem academic. However, it has practical implications for advisors. Most importantly, you want to do what is in the best interest of your client. If your client is best served by using low-cost passive funds because active management truly doesn’t add value, then so be it. However, utilizing only passive funds eliminates one of your value propositions as an advisor – evaluating and selecting funds – and removes any possibility of outperformance, so, from a business perspective, it is probably preferable to keep at least some active management in the mix.
The tables below show the quarterly, year-to-date, and rolling five-year return rankings of several well-known indices (representing passive management). If the index ranks in the top two quartiles, then it outperformed most managers within the peer group during that period. Conversely, if the index ranks below the 50th percentile, then most active managers in that universe outperformed the benchmark. Looking at the rankings over time, we can get a feel for which markets are the most efficient, and thus are likely to favor passive management, and which are the least efficient, offering the greatest opportunity for active managers.
The earliest five-year period in our long-term rankings began in June 2017 and the most recent period ended September 30 2026. During that time, we have experienced several different market environments and market-shaping events from the calm of 2017 to the volatility of 2020 and the tariff-driven drawdown last year. So, we have a good cross-section of market states upon which to base our conclusions.
US Large Cap Equities
The S&P finished the third quarter in the second quartile of the rankings, where it also currently sits on a year-to-date basis. This is in-line with what we've seen over the long-term as the S&P has finished in above the 50th percentile in every rolling five-year period in our lookback window, suggesting a possible advantage for passive management in the US large cap space.
US Small Cap Equities
The Russell 2000 finished the third quarter right around the 50th percentile and sits just inside the second quartile on a year-to-date basis. While most active managers have underperformed the index this year, over the long-term it appears there may be an advantage for active management in small caps as the Russell 2000 has finished in the bottom half of the rankings in every rolling five-year period and has often ranked in the bottom quartile.
Developed International Equities
The MSCI EAFE Index sits right around the 50th percentile on both a quarter and year-to-date basis. This is similar to what we see over the long-term as the index has often finished just above or just below the mid-line in our longer-term rankings, providing no convincing evidence of an advantage to either active or passive management.
Emerging Market Equities
Like its developed market counterpart, the MSCI Emerging Markets Index sits right around the 50th percentile on both a quarterly and year-to-date basis. However, unlike international developed markets, the longer-term rankings for emerging markets show a possible bias towards active management as the index has finished in the bottom half of the rankings in every five-year period in our lookback window.
US Core Fixed Income
The Bloomberg US Aggregate Bond Index finished the third quarter above the 50th percentile, an unusually strong showing for the index. Over the long-term, however, the rankings show a clear advantage for active management in US core fixed income as the Agg has finished in the bottom quartile of the rankings in every five-year period in our lookback window.
