Why active investing falls behind after fees

If I could recommend only one article about the stock market, it would be economist William Sharpe's The Arithmetic of Active Management. It explains one of the market's fundamental principles. It changed how I think about investing, and I hope it does the same for you.

In any market, such as the Canadian stock market, investors can be divided into two groups. Index investors hold the market portfolio. Active investors depart from it because they are trying to do better.

Sharpe's central point is simple. Before transaction, management, and operating costs, both groups collectively earn the market return. Active investors generally pay higher costs, so after fees their collective return is lower.

The word "collectively" matters. There are winners and losers among active investors. Some will grow much wealthier than others. But as a group, active investors earn less than index investors after fees.

Why can active investors not beat the market as a group? Because they are the market.

A market is the sum of every investor's portfolio. The market return is therefore the weighted average return of all investors. Larger portfolios have more influence on that average than smaller ones.

Index investors hold the market portfolio and receive the market return before costs. Once their holdings are removed from the whole market, everything left belongs to active investors. Their collective return must also equal the market return before costs.

An active investor can still beat the market. But that outperformance is offset by underperformance elsewhere among active investors. Relative to the market, active management is a zero-sum game before costs.

After costs, it becomes a negative-sum game. Active investors pay more for research, security selection, trading, and advice. Collectively, they keep less.

The conclusion does not depend on a forecast about the economy or next year's stock market. It follows from simple arithmetic: investors collectively own the market, and every dollar paid in costs is one less dollar they keep.

The guide to active versus index investing explains the difference between the two approaches.

Active management asks you to choose a manager who can outperform by enough to cover the additional cost. Index investing accepts the market return at a generally lower cost.