Can Active Fund Managers Consistently Outperform the Market? (Part One)

Let us begin by defining active and passive fund management. Active fund management is an investment strategy where fund managers actively buy and sell assets—specifically stocks—within a fund, with the goal of outperforming a specific benchmark. Passive fund management, by contrast, is an investment strategy that aims to replicate the performance of a specific market index rather than trying to outperform it.

When I refer to active fund management, I am not talking about systematic factor investing strategies—like size, value, profitability, quality, et cetera—that deviate from the market index. I am talking about traditional discretionary active fund management, where managers select individual stocks as defined above.

So, to address the question with the above in mind, let us break down the facts:

1. Active Management Costs Are Higher

Active management costs are higher than those of passive management and so active funds start with a disadvantage. This is because the returns of an active fund must first cover the cost differential between the active and passive fund.

2. Active Management Is a Zero-Sum Game Before Costs

Active management is a zero-sum game before costs and a negative-sum game after costs. In a zero-sum game, one participant’s gain is exactly offset by another participant’s loss. The total ‘winnings’ and ‘losses’ net to zero. In financial markets, every trade has a buyer and a seller. If one party outperforms the market, another must underperform by the same amount. The market as a whole contains every active fund manager. So, joining this up with the point above, before costs, the average performance of all active managers equals the market return. After costs, the average active fund manager underperforms the market by their cost differential (Sharpe 1991).

3. Efficient Markets and Short-Term Prediction

The Efficient Market Hypothesis (EMH), developed by Eugene Fama—a Nobel laureate and one of the most highly cited researchers in finance—says that all past information is already reflected in current prices (Fama 1970). As such, short-term price changes reflect new information, which is unpredictable. Empirically, many studies show that daily or weekly returns have near-zero autocorrelation—meaning that returns are close to random from one shorter period of time to the next (Lo and MacKinlay 1999). It follows, then, that it would be unreasonable for an active manager to expect their ex-ante analysis to predict short-term future price movements and to subsequently outperform a given index.

4. Momentum and Medium-Term Prospects

But what about the medium to longer term? Momentum is a real, well-documented anomaly, and it suggests that stocks that have done well in the recent past tend to keep doing well. This typically lasts for around 3–12 months (Jegadeesh and Titman 1993). So, in theory, a skilled active manager could find outperforming stocks and hold onto them for this time period.

However, even if they are able to find the out-performers, in reality, the costs and constraints of such a strategy will almost certainly outweigh any momentum premium. These include switching fees, liquidity limits, transaction costs, and risk/capacity constraints. This is also assuming that the active fund manager could actually identify these outperforming stocks in real time, i.e., without the benefit of hindsight. Not so easy, as we will come onto.

5. Speed and Sophistication of Modern Markets

New (unexpected) news is ‘priced in’ instantaneously. Markets—particularly in large caps—are close to being perfectly efficient. Annual reports and other sources of information can be read by high-powered computers in micro or even nanoseconds, and discount rates and expectations of future cash flows are also adjusted in these time frames (Aldridge 2013). Any kind of fundamental or technical analysis done after the fact is simply too late.

If you are not already aware, I would suggest looking into firms like Citadel Securities, Millennium Management, Two Sigma, Jane Street, and Virtu Financial. There is a great article by the Financial Times titled “The New Titans of Wall Street” (Wigglesworth 2023). The people working at these firms are among the smartest, hardest-working, and best-educated in the world. Furthermore, they have the best tools and resources. If even they struggle to beat the market consistently, what chance does the average active fund manager have?

6. Positive Skew in Stock Returns

There is huge positive skewness in stock returns. The positive mean-average return of the market comes from very few stocks. Only 1.33% of global stocks accounted for all net global wealth creation from 1990 to 2018 (Bessembinder 2018). Can active fund managers find these consistently?

A fact is that in the US large cap market, fewer active managers consistently outperform the market than would be expected by chance (S&P Dow Jones Indices 2024). Let that sink in. Even in the small cap market, SPIVA (S&P Indices Versus Active) data consistently show that most active small-cap managers underperform their benchmarks after fees (S&P Dow Jones Indices 2024). Therefore, the empirical data overwhelmingly say that active managers cannot find these outperforming stocks consistently.

7. Diversification vs. Outperformance

On top of the above, active fund managers must hold enough of the few outperforming stocks in order to outperform. I.e., they must have an overweighting in these positions. And yet, we are told by the same active fund managers that diversification should be at the heart of a well-put-together fund in order to reduce non-systematic risk… It seems to be a catch-22. In order to outperform the index, an active manager must take excessive amounts of uncompensated idiosyncratic risk; a sub-optimal strategy.

Equally, to protect against the downside, active managers must hold enough of the few outperforming stocks in order to reduce the drawdown of the fund versus an index.

Final Thoughts

The theoretical and empirical evidence is clearly stacked against traditional discretionary active fund management. From the zero-sum nature of active investing and the challenge of costs, to the near impossibility of predicting short-term price movements and the fierce efficiency of modern markets, it becomes clear why consistent outperformance is so elusive. While the allure of ‘beating the market’ remains strong, the theory overwhelmingly suggests that for most investors, passive strategies offer a more reliable, cost-effective path to long-term wealth accumulation.

References

Aldridge, Irene. High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems. Hoboken, NJ: Wiley, 2013.

Bessembinder, Hendrik. “Do Stocks Outperform Treasury Bills?” Journal of Financial Economics 129, no. 3 (2018): 440–457.

Fama, Eugene F. “Efficient Capital Markets: A Review of Theory and Empirical Work.” Journal of Finance 25, no. 2 (1970): 383–417.

Jegadeesh, Narasimhan, and Sheridan Titman. “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” Journal of Finance 48, no. 1 (1993): 65–91.

Lo, Andrew W., and A. Craig MacKinlay. A Non-Random Walk Down Wall Street. Princeton: Princeton University Press, 1999.

S&P Dow Jones Indices. SPIVA U.S. Scorecard, 2024. https://www.spglobal.com/spdji/en/research-insights/spiva/.

S&P Dow Jones Indices. 2024. SPIVA U.S. Year-End 2024. Accessed April 14, 2025. https://www.spglobal.com/spdji/en/spiva/article/spiva-us/. 

Sharpe, William F. “The Arithmetic of Active Management.” Financial Analysts Journal 47, no. 1 (1991): 7–9.

Wigglesworth, Robin. “The New Titans of Wall Street.” Financial Times, January 2023. https://www.ft.com.