Why active funds underperform even when the manager picks well
- Robin Powell
- Jun 8
- 7 min read
Ask why active funds underperform and the usual reply is that the managers cannot pick stocks. New evidence points somewhere less comfortable: even when the picks are right, the trading around them quietly hands the gains back.
Picking winning stocks is hard, and the managers running the largest active funds are, for the most part, not too bad at it. They employ analysts, meet company management and sift research to build portfolios designed to beat the market, and many succeed at precisely that. The awkward part comes next: the funds those same managers run frequently fail to beat it.
The year 2025 made the point cleanly. The stocks held by the 100 largest active US stock funds, taken together, beat the market. Yet nearly two-thirds of the funds still lagged their benchmark over the year, according to an analysis by Jeffrey Ptak, managing director for Morningstar Research Services. The gap was not in the picking. It was in everything that came after, and it points to why active funds underperform even when the stock selection is sound.
What Morningstar's do-nothing experiment found
To find where the value leaked away, Ptak ran a simple experiment. He froze the funds' aggregate holdings at the start of the year and let them ride, then compared that hypothetical buy-and-hold portfolio with what the managers actually achieved by trading. The frozen portfolio won. Across 2016 to 2025 it returned 14.3 per cent a year against the funds' 13.4 per cent, close to a full percentage point lost to trading each year. A version frozen for the entire decade from the end of 2015 did better still, returning 15.2 per cent a year, ahead of both the funds, on 13.8 per cent, and the index itself, on 14.9 per cent.
This was not a quirk of a rising market. Doing nothing beat the actual funds in nine of the past ten years, including the falling markets of 2018 and 2022.
One caveat matters. The do-nothing returns exclude fees, and the funds charged an asset-weighted 0.59 per cent. So the reading is narrower than idleness beating professionals: the managers' trading gave back roughly what their stock-picking had earned, and the fees did the rest. Ptak's column is one analyst's analysis of US funds, not peer-reviewed work. What gives the pattern its weight is the academic evidence on why the trading costs so much.
Skilled at buying, poor at selling
The first reason lies in how professional investors handle the two halves of a trade. A 2023 study in The Journal of Finance, by Klakow Akepanidtaworn, Rick Di Mascio, Alex Imas and Lawrence Schmidt, examined 783 institutional portfolios averaging $573 million and some 4.4 million trades between 2000 and 2016. On the way in, the managers showed genuine skill. On the way out, they destroyed value.
The authors measured each sale against a naive alternative: selling a holding picked at random from the portfolio. The managers' actual sales did worse, at a cost of roughly one percentage point a year. As they put it, 'selling decisions underperform substantially, even relative to random-selling strategies'. Their explanation is limited attention. Managers pour research into what to buy and treat selling as an afterthought, reaching for whatever rule of thumb is nearest to hand. That reading is the authors' interpretation rather than established fact, and the sample is institutional investors broadly, not mutual-fund managers alone. But the asymmetry is hard to miss. The same people who buy with care sell almost carelessly, and the carelessness has a price.
Trading costs and why active funds underperform
The second reason is the cost of the trading itself. The foundational measurement comes from Russ Wermers of the University of Maryland, whose 2000 study in The Journal of Finance broke down US fund returns from 1975 to 1994. Funds' stock holdings beat the market by 1.3 percentage points a year before costs; investors trailed it by one point a year after them. Of the 2.3-point gap, expenses and transaction costs accounted for 1.6 points and a cash drag for the rest.
The data are old; the mechanism has proved durable. Roger Edelen, Richard Evans and Gregory Kadlec, writing in the Financial Analysts Journal in 2013, found that active funds' trading costs averaged 1.44 per cent of assets a year, more than the 1.19 per cent the same funds charged through their expense ratio. Most of that cost is invisible. About 80 per cent of it comes from bid-ask spreads and the price impact of large orders, not the commission the investor can see.
The more a fund trades, the more it leaks, which is one of the better-documented reasons active funds underperform. Funds in the highest trading-cost quintile lagged the lowest by around 1.78 percentage points a year on a risk-adjusted basis. And the cost climbs fastest in exactly the corner managers point to as their edge: in the same study, small-cap growth funds bore trading costs of around 3.17 per cent a year against 0.84 per cent for large-cap value. A separate working paper by Jeffrey Busse and colleagues put fund trading costs lower, at about 0.75 per cent a year, but pointed the same way.
Why managers keep trading
If the trading costs so much, why do skilled managers keep doing it? Largely because much of it is not high conviction in the first place. It is what the structure around the manager demands.
Ptak's own explanation is organisational rather than psychological: managers are skilled and well-motivated, but the institutions they work inside reward activity. Three strands of research show how. Lukasz Pomorski, in a 2009 working paper, found that the trades which were not a manager's best ideas failed to beat a passive benchmark even before expenses, returning an average of about 0.03 per cent a month, a figure statistically indistinguishable from zero. Judith Chevalier and Glenn Ellison, writing in The Quarterly Journal of Economics in 1999, found that younger managers facing a credible threat of dismissal held more conventional portfolios, trading to protect a career rather than to add return. And Roger Clarke, Harindra de Silva and Steven Thorley showed in 2002 that long-only limits, tracking-error caps and sector rules leave a manager acting on only a fraction of their insight. Low-conviction ideas, career caution, mandate constraints: three pressures, all producing trades the manager would not otherwise make.
When trading is not the problem
None of this makes activity itself the villain. Martijn Cremers and Ankur Pareek, in a 2016 study in the Journal of Financial Economics, found that among funds taking genuinely different positions from the index, only those that held their bets patiently, for more than two years, outperformed, and by more than two percentage points a year. The high-conviction funds that traded quickly generally did not. A 2021 study in the Journal of Banking & Finance, by Ke Shen, Lin Tong and Tong Yao, found the same uneven pattern, with frequent trading dragging on the returns of unskilled managers but not skilled ones.
The distinction matters. The problem the evidence keeps pointing to is not trading as such, but reactive, low-conviction churn — the motion that fills the space between a manager's few good ideas. The funds that win are the ones that resist it.
What it means for UK investors
For a UK investor the question is whether this holds at home. It does. The SPIVA scorecard, compiled by S&P Dow Jones Indices, tracks active funds against their benchmarks in sterling terms, and over the ten years to the end of 2025 the failure rate ran above 90 per cent across the major UK and global equity categories: 94.9 per cent of UK Large-/Mid-Cap funds lagged their benchmark, and 97 per cent of sterling global equity funds. On a risk-adjusted basis, not one of the sterling US equity funds measured beat its benchmark over the decade.
The figures also flatter the survivors. Only four in ten UK Large-/Mid-Cap funds lasted the full ten years; the rest closed or merged and dropped out of the table. The picture, in other words, is worse than the headline, not better.
There is a structural reason the index proves so hard to beat. As Ptak observes, an index is itself close to a do-nothing strategy. It pools the decisions of many managers, so that one manager's buy is offset by another's sell and the trading nets out. The index wins, in part, by not doing the thing active managers cannot stop doing, which is much of the case for indexing in a single sentence.
Resources
Akepanidtaworn, K., Di Mascio, R., Imas, A., & Schmidt, L. D. W. (2023). Selling fast and buying slow: Heuristics and trading performance of institutional investors. The Journal of Finance, 78(6), 3055–3098.
Busse, J. A., Chordia, T., Jiang, L., & Tang, Y. (2014). Mutual fund trading costs and diseconomies of scale [Working paper].
Chevalier, J., & Ellison, G. (1999). Career concerns of mutual fund managers. The Quarterly Journal of Economics, 114(2), 389–432.
Clarke, R., de Silva, H., & Thorley, S. (2002). Portfolio constraints and the fundamental law of active management. Financial Analysts Journal, 58(5), 48–66.
Cremers, M., & Pareek, A. (2016). Patient capital outperformance: The investment skill of high active share managers who trade infrequently. Journal of Financial Economics, 122(2), 288–306.
Edelen, R. M., Evans, R. B., & Kadlec, G. B. (2013). Shedding light on 'invisible' costs: Trading costs and mutual fund performance. Financial Analysts Journal, 69(1), 33–44.
Pomorski, L. (2009). Acting on the most valuable information: 'Best idea' trades of mutual fund managers [Working paper]. SSRN.
Ptak, J. (2026). The biggest active stock funds picked the right stocks. They still lagged. Morningstar.
S&P Dow Jones Indices. (2026). SPIVA Europe year-end 2025 scorecard.
Shen, K., Tong, L., & Yao, T. (2021). Heterogeneous turnover–performance relations. Journal of Banking & Finance, 124, 106054.
Wermers, R. (2000). Mutual fund performance: An empirical decomposition into stock-picking talent, style, transactions costs, and expenses. The Journal of Finance, 55(4), 1655–1695.
If you're questioning your own funds
If this evidence has left you wondering whether the active funds in your own portfolio are quietly leaking returns the same way, a sensible next step is to talk to an adviser who already works from this research. TEBI's Find an Adviser directory lists professionals who have publicly committed to evidence-based investing: low-cost, globally diversified and built around what the data shows rather than what a manager promises.
For readers who would rather work through the case themselves first, How to Fund the Life You Want by TEBI editor Robin Powell and Jonathan Hollow sets it out at book length. Bloomsbury published the second edition, written for UK investors. It is available on Amazon.
