That’s a good question! Here are some of the answers:
- Fund returns are after fees paid to the fund manager and active funds charge considerably higher fees than passive index funds
- Active funds do not deal with risk appropriately. They identify target stocks well but fail in portfolio construction that optimizes for risk. A broad market index is a relatively well-diversified portfolio. But see the analysis of Active Share in chapter 1. There are effective stock pickers versus clowns.
- Active funds build in protection from downside risk by investing in hedging instruments or with an allocation to the relative safe equities of chapter 8. Downside risk is reduced but with lower upside. Hedging is buying insurance and insurance is costly, reducing overall returns. So, active funds should have lower returns than index returns that are not hedged. The latter are exposed to risk and risk earns higher returns.
- Funds that have a high return in a particular year by luck, advertise that return, drawing naïve investors to the fund, only to earn lower returns with the added funds in later years.
- Marketing: As fees are typically based on AUM rather than returns, fund managers chase AUM and do so with marketing to lure naïve investors.
- Many passive funds focus on the broad market, index funds explicitly. Thses funds have significant holdings in the large firms…the Magnificent Seven tech stocks recently… that have done well but which active investors have avoided due to a sense that they are overvalued.
- Up to the present, we have not witnessed the risk in passive funds. The history of passive investing has been in an era of largely good outcomes for the economy and the stock market (at least in the U.S.). Though there were hiccups in the financial crisis of 2008, we have not yet seen the so-called peso effect of a big but infrequent wipeout.
- The returns for active funds in recent history have been affected by the flow of funds from active funds to passive funds. Redemptions from passive funds forces the fund managers to sell off the potentially profitable investments to satisfy the liquidity requirements, reducing their returns.
- Many active funds are just poor investors earning lower returns: Clowns.
We are not sure how much weight to put on each of these explanations; more empirical evidence
is necessary. A paper shows that reported sub-index performance can be due to funds building in a hedge against losses in their investment strategies. An equity fund might invest some equities that are less susceptible to the downside, for example. That loses some upside return, lowering overall return but avoiding some downside. It’s like buying insurance that protects against bad outcomes but at some cost (of the insurance premium).
See Penman, S. and Y. Zou. 2024. Benchmarking Investment Fund Performance for the Multiperiod Investor. At https://ssrn.com/abstract=4258091.
Interestingly, such “safe equities” that provide the insurance are discovered with fundamental analysis, as in chapter 8.