The first argument in favor of passive management is theoretical on a purely mathematical basis. The average performance of active funds should match the market return since active fund managers are participants in the market and abnormal returns within a portfolio should be a zero-sum gain across the whole Market since the fund manager that buys an outperforming stock must have bought it from someone who isn't experiencing that good performance since they don't own the stock anymore.

Another way of thinking about this as suggested in 1991 by William shop. After whom the sharp ratio is named is to say that if the market is made up of active and passive investors, then the passive investors will earn the return of the market since they are passively holding the stocks within the market and therefore the active managers must also on average and the return of the market since together active and passive investors. Make up the entire Market between them.

This implies that there is no point paying the higher fees for active management since on average active managers should generate the same return as passive managers. And the best that you can do is just to earn the return of the market as cheaply as possible through a passive fund.

In addition to the theory there have been an extensive number of academic studies carried out over a number of years to suggest that active managers on average do underperform their benchmarks after their fees are taken into account which backs up the theoretical point from before that. There's no point in paying the higher fees for active funds and a better alternative would be to invest in a passive fund.

This is however only looking at the average return of active managers and within this average there will be some portfolio managers who outperform the average and some who will underperform it. So if an investor picks a good fund manager, they would be able to beat the market that does then raise the question as to whether it is possible to identify a good portfolio manager in advance. This is easy to do at the end of a period but for an investor to earn that good performance, they would need to have invested in the fund at the beginning of a period it is possible to look back at past performance. But as all the financial adverts tell us past performance is no guarantee feature performance.

But is it an indicator at all? There is some evidence that the performance of good fund managers isn't sustained over time and that performance declines with time.

Originally from a paper by Mark Carhart in 1997, which found no Persistence of performance due to fund manager skill and more recently a study carried out by S&P Dow Jones indices found that only 36% of the top quartile Us by managers for the year ended June 2018 remained in the top quartile for each of the next two years and less than 2% of the top quartile Farm managers for the year ended June 2016 remained there for each of the next four subsequent years suggesting that top quartile fund managers in one period cannot consistently remain top quartile managers over time.

This would then indicate that using past performance as an indicator of identifying good for managers is not a reliable approach.

So if active managers are underperforming on average, why is this the case? Despite portfolio manager roles typically being held by those with substantial experience of making investment decisions one suggestion. Is that within Equity markets the distribution of stock performance around the market average is not symmetrical but rather positively skewed.

So that the best performing stocks perform a lot better than the average but there isn't the same corresponding effect for Worse performing stocks. This means that it is going to be harder for an active manager to identify the really high performing stocks and overweight them in their portfolio due to the relatively low number of these stocks a portfolio manager who has not overweighted these very good stocks in their portfolio will struggle to outperform The Benchmark the final argument against active funds and in the favor of passive funds is that there are a number of closet index funds. This means that although these funds describe themselves as active funds and charge management fees accordingly. They're Holdings closely match those of the index.

Such funds are highly unlikely to beat their Benchmark despite charging higher fees to their client.

These funds do Market themselves as active funds which raises challenges for investors to identify those funds that are closet index funds or which have Holdings very close to the benchmark.