Why Passive Investing Still Beats Active
By James Parkyn - PWL Capital - Montreal
If you read this blog, you know the evidence about active versus passive investing. It consistently shows that the vast majority of actively managed funds fail to beat the market over the long run.
The reasons are simple. It’s very hard to time the market and pick stocks that will outperform. Even when an active manager makes some good calls, it’s even rarer to do so consistently over the long run, especially as higher fees gobble up gains.
The most striking data about this comes from the annual SPIVA reports on actively managed funds. They show year after year that actively managed funds lag the market.
98% of funds underperformed
In 2024, the report found that a whopping 98% of multi-cap funds underperformed the S&P 500 Composite Index over the prior 10 years.
Investors have heeded all this evidence. U.S. active equity mutual funds saw over $1 trillion in net outflows in 2025—the 11th consecutive year—according to a report by analyst Larry Swedroe.
Meanwhile, passive equity exchange-traded funds attracted more than $600 billion.
Market efficiency being eroded?
Despite the data, advocates of active management haven’t given up. They’re now making an interesting new argument—claiming that the net outflows may actually help stock pickers.
“The narrative goes like this,” Swedroe wrote about these claims. “As more investors abandon active management for passive index funds, price discovery will deteriorate, markets will become less efficient, and opportunities for skilled stock pickers will multiply…
“There’s just one problem: reality refuses to cooperate.”
Swedroe noted that if the thesis were correct, the steady outflow of funds quitting active management should have led to improved performance against benchmarks. “Instead, we’ve seen the opposite,” he said.
The other side of the trade
Who is correct? Is active investing is getting new life? Has the rise of passive investing indeed imperilled market efficiency?
Weighing into the debate is Morgan Stanley with a new report titled, “Who Is On the Other Side?” The authors are well-known Columbia Business School adjunct professor of finance Michael Mauboussin and his long-time collaborator Dan Callahan.
They look at the question through a unique perspective that’s sometimes overlooked. When you’re buying a stock, there’s a seller on the other side. It’s useful to ask yourself: What does the seller know that I don’t? The same is true if you’re selling.
Professionals help boost market efficiency
Who then is on the other side of a trade in today's markets? These are mostly institutional players, retail investors, sovereign wealth funds, day traders, hedge funds and other professionals. All these actors help make the market more efficient.
Before we go further, let me explain market efficiency. This is the notion that markets accurately reflect available information. In other words, an investor can never get an edge because markets have already priced in all relevant information.
The inventor of the idea, Nobel Laureate Eugene Fama of the University of Chicago, broke it down into three levels.
Weak market efficiency means prices reflect all past data. In semi-strong efficiency, prices reflect all publicly available information. Strong market efficiency means prices reflect all available information, including private data.
Act as though markets are perfectly efficient
In over 25 years of experience as portfolio managers at PWL Capital, we can safely say markets are not perfectly efficient. Fama agrees. At the same time, his view is it’s in your best interest to act as though the market is perfectly efficient.
In other words, assume you have no edge. We at PWL agree with this.
Traders of all sorts are always looking to find pricing inefficiencies. This is the basis of trying to pick stocks and time the markets. But as Mauboussin and Callahan point out, if you want to beat the market, you need a competitive advantage over other market participants.
Every time you buy or sell a stock, someone else is on the other side of the trade. To beat them, you need an edge over them.
2% of companies = nearly 90% of wealth
Determining the fair value of a stock requires you to know the future value of the cash flow of a company and discount rate. That means forecasting the future.
The evidence shows this is very hard to do. Only about 2% of companies created nearly 90% of the total wealth in the market during the last century, Morgan Stanley’s report said. This is consistent with data we reported in our blog that found just 4% of stocks accounted for all stock market wealth creation above a risk-free investment in Treasury bills from 1926 to 2023.
The likelihood of identifying these 2% or 4% of stocks ahead of time is very slim. Mauboussin and Callahan say this requires an edge in four distinct areas.
Behavioural—You need to be more rational than other investors.
Analytical—You must be able to predict which businesses will outperform.
Informational—You need in-depth research giving you valuable information unavailable to others.
Technical—You need to be able to exploit temporary imbalances between supply and demand for a security.
If it sounds challenging, you are right. It is. Most retail investors don’t have the time, knowledge or expertise to gain an edge in these areas. Don’t forget who is on the other side of the trade: professional investors with a team of analysts and vast resources. And even most of them can’t consistently beat the market.
What is your specific edge?
If you conclude that you don’t have an edge, you shouldn’t be trying to actively trade. Instead, the best thing to do is adopt a passive diversified portfolio to capture the broad market’s returns. This means you’re sure to get exposure to the small fraction of companies that will deliver outsized gains in the long run.
If you’re trying to pick stocks, you could get lucky—for a time. But don’t confuse luck with skill. The same applies to picking an active manager. Picking the few who will outperform is called gambling.
Shift in mindset
Accepting market efficiency is a shift in mindset. It leads an investor to stop wasting its time and energy on trying to forecast markets, pick stocks or mutual fund managers. You can focus on things that do matter.
This includes assessing your risk tolerance and finding the right balance of diversified stocks and bonds to meet your goals. It means being disciplined about sticking with your investing strategy.
By adopting a new mindset, you can sit back and let the (more or less) efficient market do its thing.
Find more commentary on personal finance and investing, our podcast, past blog posts, eBooks, model portfolios and market statistics on the website of PWL Capital’s Parkyn-Doyon La Rochelle team and our Capital Topics website.