Why Investing Passively Outperforms Active Management?

Empirical research has shown that the vast majority of day-traders lose money. These investors tend to believe that by trading actively in the markets, they can beat simply buying a passively managed index fund. We are going to show that not only are the odds stacked against the amateur investor to beat the underlying benchmark, but that a huge percentage of (‘professional’) actively managed funds also succumb to the same fate.

Fees

In the traditional markets, actively managed funds typically charge their investors anywhere between 5 and 10 times the fee of a passively managed fund. In addition, these active funds will also incur a higher amount of transaction fees as a result of their active management. Both these factors combined provide a performance threshold which the fund must achieve just to breakeven with the comparative index.

For individual day traders, the situation worsens as their transaction fees as a percentage of their investment value tend to be higher. This is due to the fact that they lack scale and thus are not able to negotiate lower fees. Even if a fee isn’t being directly charged, it is baked into the spread or your order is being picked off by Citadel.

Asset Selection

Asset selection is paramount to a fund’s performance. Active funds typically exhibit a common theme which is that the larger their AUM grows the lower their excess returns become. This is due to the fact that their larger capital base forces them to restrict their asset universe to only the most liquid. Since the most liquid assets are also owned by index funds, the performance of these active funds converges with that of the index. But due to higher fees and, generally speaking, a lack of clairvoyance when it comes to asset selection these active funds end up underperforming the passive index funds.

Individual day traders tend to trade in the most liquid assets, accompanied by the most informed and sophisticated trading outfits on the planet, leaving them little to no edge on small time frames. Given the vast amounts of data to assimilate, it is virtually impossible to predict the future over a short time horizon.

Performance Biases

Besides fees and asset selection, active management also introduces a number of intangible factors to deal with. These include biases and conditioning, as a result of past experiences, that subconsciously affect an active investor’s decision making.

Behavioural biases

On the contrary, passively managed funds follow a predetermined set of rules which removes uncertainty from the decision-making process and alleviates negative performance attributed to emotions.

Performance

In traditional finance, index products account for the largest AUM of any fund strategy. As of 2020, more than $10 trillion was invested into passively managed index funds.¹ Index funds look to match the market’s risk and return on the theory that the market will outperform any single investment in the long term.

Looking at the historical data is polarising. For the year 2020, 60.33% of all large-cap funds underperformed the S&P 500 and over the last 20 years, a massive 94% of these funds have underperformed the benchmark.² Less than one in ten active funds proved to be a better investment than a passively managed index fund over the last two decades.

Report: Percentage of U.S. Equity Funds underperforming their benchmarks | credits: SPi Global

Investment Strategy in Crypto

Crypto is predominantly made up of active investment strategies, with the majority of early investors diving deep into each project they invest into. According to Defi Pulse, of the ~$54 billion locked into decentralised finance protocols, only around 146.4 million is held by index funds. Just 0.27%! Over 45% of equities held by U.S. funds are in passive fund structures, and whilst not an apples to apples comparison, I think it illustrates the differential in investment strategies between crypto and TradFi. Our view is that as the crypto markets mature, the differential just mentioned will dissipate. We believe that future crypto investors will want diversified exposure to the crypto markets without having to deep dive research into each project.

That is why we are building Phuture, a platform that lets people create, invest and manage their tokenised passive investment strategies. Phuture’s platform gives investors the tools they need to create and invest into indices that suit their market outlook or existing portfolio. All Phuture indices benefit from dynamic band auto rebalancing and auto reweighting of index components. Moreover, index holders benefit from additional performance obtained on yield optimisation platforms like yearn.

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