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Why most active funds underperform: costs, arithmetic and luck
Why most actively managed stock funds trail their index over time: Sharpe’s arithmetic, costs, skewed stock returns, survivorship and luck.
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An actively managed fund pays professionals to pick stocks, aiming to beat an index. The idea is appealing, and some managers do it for years. But the evidence on the group as a whole has been consistent for decades: in most periods, most active US stock funds trail the index they are measured against, and the longer the period, the larger the share that falls behind. S&P Dow Jones Indices' year-end 2025 scorecard found that 92.9% of US large-cap active funds trailed the S&P 500 over the 20 years to December 2025.
This article is about why. The Index investing: passive vs. active funds and what the data shows guide presents the SPIVA numbers in detail; here the focus is on the mechanisms: a piece of arithmetic published by William Sharpe in 1991, the steady drag of costs, the way a few huge winners dominate stock-market returns, funds that quietly disappear, and how hard it is to tell skill from luck. None of this says active management can't work. It explains why it is hard, and what has to be true for it to work.
The arithmetic of active management
In 1991 William Sharpe, a Nobel laureate in economics, published a two-page article that remains the cleanest explanation of the result. It needs no data, only two definitions.
- A passive investor holds every security in the market in proportion to its market value, the way an index fund does.
- An active investor is anyone who doesn't: anyone who over- or under-weights some securities relative to the market.
Every share in the market is owned by someone, so passive and active investors together own the whole market. Passive investors, by construction, earn the market's return before costs. Therefore the active investors, taken together, must also earn the market's return before costs: their holdings are simply "the market minus the passive part," which has the same weights as the market.
Sharpe stressed that the conclusions hold over any period and depend only on the laws of addition and subtraction. They describe the average active dollar, not every active fund. For each active investor who beats the market before costs, others must trail it by the same amount. Active management, as a whole, is a zero-sum game before costs and a negative-sum game after them.
Costs: the hurdle that never goes away
If the average active dollar can only match the market before costs, everything comes down to costs. Active funds carry several layers:
- The expense ratio. The annual fee for management and operations, deducted from the fund's assets (Expense ratios and fund costs: what you pay and how it compounds). Actively managed stock funds charge several times what broad index funds do; a large S&P 500 index fund can cost under 0.10% a year (SPY's gross expense ratio was 0.0945% as of October 2026).
- Trading costs. Commissions, bid-ask spreads and market impact from buying and selling. Funds with high turnover pay more, and these costs come out of returns without appearing in the expense ratio.
- Cash drag. Active funds usually keep some cash to meet redemptions, which earns less than stocks in a rising market.
- Taxes. In a taxable account, frequent trading realizes capital gains that the fund distributes to shareholders each year.
- Sales charges and advice fees. Loads, 12b-1 fees or an advisory wrap on top of the fund, where they apply (Mutual funds explained: NAV, share classes, loads and 12b-1 fees).
Why "most" funds trail, not just "the average"
Sharpe's arithmetic covers the average dollar. The SPIVA numbers say something stronger: most funds trail, often a large majority. Several things push the median fund below the average.
Stock returns are skewed
Over long periods, a small number of stocks produce enormous returns, while most stocks do far less. Hendrik Bessembinder's 2018 study of US stocks from 1926 to 2016 found that more than half had lifetime returns below those of one-month Treasury bills, and that about 4% of listed companies accounted for all of the stock market's net wealth creation over that period. An index owns all the extreme winners by construction. A manager who holds 50 or 100 stocks will, more often than not, miss some of them, and in a skewed distribution "more often than not" means the typical concentrated portfolio trails the index even before costs.
Concentrated markets add to it
When a handful of mega caps lead, as in 2023 and 2025, managers who hold smaller positions in them than the index does fall behind. In 2025, a year dominated by the largest companies, 78.8% of US large-cap active funds trailed the S&P 500, up from 65% in 2024. Market concentration: what mega caps mean for S&P 500 investors shows how wide the gap between cap-weighted and equal-weighted versions of the same index was over 2021 to 2026.
Survivorship hides the losers
Funds that trail tend to shrink, then close or merge into other funds, and their records vanish from most databases. Looking only at funds still alive today flatters the industry. SPIVA counts the dead: of the 2,818 US domestic stock funds that existed at the start of the 15 years to December 2025, only 50.92% were still operating at the end. Any "most funds beat the market" claim built only on survivors is biased upward.
The longer the period, the more costs dominate
Over one year, luck can easily outweigh a 1% cost gap. Over 20 years, the cost gap accumulates while luck partly averages out, so a growing share of funds falls behind. That is the pattern in the scorecard:
| Period to Dec 31, 2025 | Share of US large-cap active funds trailing the S&P 500 |
|---|---|
| 1 year | 78.78% |
| 3 years | 66.84% |
| 5 years | 88.96% |
| 10 years | 85.59% |
| 15 years | 89.93% |
| 20 years | 92.89% |
Source: S&P Dow Jones Indices, SPIVA U.S. Year-End 2025, all large-cap funds, absolute returns. The figures do not rise in a straight line (the 3-year share is the lowest), but over 15 and 20 years about nine in ten funds trailed.
Luck, skill and the trouble with track records
Even if some managers have real skill, finding them in advance is hard, because luck produces impressive records too. A simple model shows how much.
Suppose a manager has no skill at all: each year their result relative to the index is random, with a typical spread of ±4 percentage points (one standard deviation, a common level of tracking error for a diversified active fund), and they pay 0.75% a year more in costs than an index fund.
| Cost gap a year | Ahead after 1 year | 5 years | 10 years | 20 years |
|---|---|---|---|---|
| 0.25% | 47.5% | 44.4% | 42.2% | 39.0% |
| 0.75% | 42.6% | 33.8% | 27.7% | 20.1% |
| 1.25% | 37.7% | 24.2% | 16.2% | 8.1% |
Two lessons. First, a one-year win is weak evidence: in this model about 43% of managers with no skill whatsoever beat the index in a given year. Second, even over 20 years a meaningful share of no-skill managers end up ahead. With thousands of funds, dozens will have impressive 10- and 20-year records by luck alone.
Researchers have tried to separate the two. Eugene Fama and Kenneth French's 2010 study of US equity mutual funds found that, after costs, the distribution of fund results looked close to what luck alone would produce: few funds showed enough skill to cover their costs. S&P's persistence scorecards ask a related question, whether top-performing funds stay on top, and they generally find that few do for long, which is what you'd expect if much of any one period's ranking comes from luck.
Why active management exists at all
If beating the market is so hard, why does anyone try? Because markets need it. Sanford Grossman and Joseph Stiglitz showed in 1980 that if prices already reflected all information, nobody would be paid to gather it, and then prices couldn't reflect it. Active investors do the research that keeps prices informative; index investors free-ride on it cheaply. The equilibrium leaves room for some skilled managers to earn their fees, but it does not promise that the average fund, or a fund chosen at random, will.
Where active funds have done better
The overall pattern is consistent, but the margins vary:
- Smaller and less-covered markets. Some small-cap and international categories have had shorter-run stretches where a majority of managers beat their benchmarks; in 2025 only about 41% of US small-cap funds lagged the S&P SmallCap 600. Over 20 years, though, most still trailed.
- Low-cost active funds start with a smaller hurdle, so a higher share of them beat their benchmarks than of high-cost funds.
- Narrow or rules-based strategies (factor funds, for example) sit between active and passive and are judged differently.
How to read a fund's record
These are questions, not a verdict on any fund:
- Compared with what? Is the benchmark the right one for the fund's style and size? A small-cap fund looks great against the S&P 500 in a year small caps lead.
- After all costs? Look at returns after the expense ratio, and consider loads and taxes.
- Over how long, and through what? A record built in one market regime may say little about the next.
- How big is the fund now? Strategies that worked with $500 million can be harder to run with $50 billion.
- What does it cost relative to an index alternative? That difference is the hurdle the manager must clear every year.
How Finabase helps you compare
- Comparison. Comparison charts several symbols on the same scale from the same start date, so you can set an active fund against an index fund in its category.
- Fund profiles. Each fund's symbol page, for example SPY, shows its quote, profile and statistics; check the expense ratio and the benchmark it states.
- Screening. The screener filters by metrics such as market cap and sector to build comparison lists.
- Concentration. The heatmap shows how much of the S&P 500 a few companies carry, the backdrop to years like 2025.
Frequently asked questions
What percentage of active funds beat the S&P 500?
It depends on the period. In S&P's year-end 2025 scorecard, about 21% of US large-cap active funds did not trail the S&P 500 in 2025, and about 7% did not trail it over the 20 years to December 2025.
Why do active funds underperform index funds?
Mainly because of costs: before costs, active investors as a group can only earn the market return, so after their higher fees and trading costs, the average active dollar must trail. Skewed stock returns, concentrated markets and the closure of losing funds make the share of funds that trail even larger.
Are there active managers who consistently beat the market?
Some have long records of beating the market, but it is hard to know in advance who they will be, because luck alone produces strong records for some managers. Studies of persistence find that few top-ranked funds stay on top.
What is Sharpe's arithmetic of active management?
William Sharpe's 1991 argument that, before costs, the average actively managed dollar must earn the same return as the average passively managed dollar, since together they make up the market. After costs, the average active dollar must therefore earn less.
Does this mean nobody should pick stocks?
No. It means the average result of stock picking, after costs, trails the index. Whether any individual or manager can do better is a separate question, and the evidence says it is a hard one.
Summary
Most active stock funds trail their index because of a simple identity and a stubborn cost. Sharpe showed in 1991 that before costs the average active dollar must earn the market return, so after costs it must trail. Costs compound, stock returns are dominated by a few huge winners that diversified portfolios often underweight, concentrated markets like 2025 widen the gap, and the funds that fail disappear from the record. The longer the period, the more these forces win out: 92.9% of US large-cap active funds trailed the S&P 500 over the 20 years to 2025. Skill exists, but because luck produces convincing records too, finding it in advance is the hard part.
Sources and further reading
- Sharpe — The Arithmetic of Active Management, Financial Analysts Journal 47(1), January/February 1991
- S&P Dow Jones Indices — SPIVA U.S. Year-End 2025 scorecard
- S&P Dow Jones Indices — U.S. Persistence Scorecard
- Bessembinder — Do stocks outperform Treasury bills? Journal of Financial Economics 129(3), 2018
- Fama and French — Luck versus skill in the cross-section of mutual fund returns, Journal of Finance 65(5), 2010
- Grossman and Stiglitz — On the impossibility of informationally efficient markets, American Economic Review 70(3), 1980
- Pedersen — Sharpening the arithmetic of active management, Financial Analysts Journal 74(1), 2018
- SEC, Investor.gov — Mutual fund fees and expenses