Active vs Passive Investing for International Investors

The Central Question

For any investor selecting between active and passive investment management, the central question is: do the costs of active management — fees, transaction costs, and the risk of manager underperformance — justify the potential for above-benchmark returns?

For internationally mobile investors, the question has additional dimensions: access to active managers may be limited by residency, active funds in some jurisdictions may not meet reporting fund requirements, and the cost structures of some international platforms make active funds more expensive than they appear.

The evidence on this question, accumulated over decades of research and summarised periodically in authoritative industry reports, is clear in broad terms but contains genuine nuance in specific market segments.

The Evidence: SPIVA and Academic Research

The S&P Indices Versus Active (SPIVA) scorecard is the most widely cited periodic assessment of active fund performance relative to benchmarks. Published semi-annually, it covers fund categories across the US, Europe, Asia, Latin America, and other regions, measuring performance after fees over 1, 3, 5, 10, and 15-year periods.

Key findings from SPIVA data (approximate, based on 15-year trailing periods):

• US large-cap equities: 85–90% of active funds underperform the S&P 500 index over 15 years.
• European equities: 75–85% of active funds underperform their benchmark over 15 years.
• Global equity funds: 75–80% underperform over 15 years.
• Emerging market equities: 65–75% underperform over 15 years — the strongest category for active, though still a majority underperform.
• Fixed income: Active funds generally fare poorly against fixed income indices after fees; 75%+ underperform in most categories over 10 years.

Survivorship bias adjustment: SPIVA accounts for survivorship bias by including funds that were subsequently closed or merged. Without this adjustment, results would be even more negative for active managers, as poorly performing funds are disproportionately closed.

Persistence: An important related question is whether past outperformance predicts future outperformance — if it does, investors could identify today's outperformers and select them. Studies consistently find very low persistence in active fund performance beyond what would be expected by chance. The majority of top-quartile managers in one period are not top-quartile in the next.

Why Active Management Struggles in Efficient Markets

The efficient market hypothesis (EMH), developed by Eugene Fama, proposes that in efficient markets, prices already reflect all available information. If true, an active manager cannot consistently exploit information not already priced in — and any apparent outperformance must be explained by luck or by taking additional risk.

Large-cap developed market equities — particularly US equities — are arguably the world's most thoroughly analysed and efficiently priced market. Hundreds of professional analysts cover every major company; information is widely available and quickly incorporated into prices; regulatory requirements ensure disclosures are standardised. In this environment, generating genuine alpha (return above the risk-adjusted benchmark) is extremely difficult and the evidence that it happens consistently is weak.

The costs of attempting to add value through active management are real and certain: management fees, transaction costs within the portfolio, and the administrative overhead of due diligence and monitoring. For a manager to add value after these costs, they need to outperform gross of fees by more than the cost of their management — a high hurdle in efficient markets.

Where Active Management May Add Value

The case for active management is stronger in less efficient markets where informational asymmetries exist and analytical skill can be rewarded:

Emerging markets: Less transparent corporate disclosure, local political and regulatory nuance, varying governance quality, and the idiosyncrasies of index construction (heavy Chinese state-owned enterprise weighting, for example) create more opportunities for skilled managers. Active EM managers have historically shown higher outperformance rates than their developed market peers.

Small-cap equities: Smaller companies receive less analyst coverage, meaning informational advantages can persist longer. Small-cap active managers have shown better relative performance than large-cap managers over time in several studies.

High-yield credit: The dispersion of outcomes in high-yield bonds (defaults, recoveries) means credit analysis can genuinely add value — a bad credit analyst misses defaults; a good one avoids them. The return from avoiding a default in a bond portfolio is asymmetric.

Specific alternatives: Private equity, infrastructure, and hedge funds (discussed in separate guides) operate in markets where active skill — deal selection, operational improvement, portfolio company governance — is fundamental to returns. There is no meaningful passive alternative in private markets.

The Cost Drag of Active Funds

The typical cost differential between an active fund and a passive index ETF for comparable equity exposure is approximately 0.7–1.2% per annum, depending on the category. This seems modest on a one-year basis but compounds significantly:

• 1% per annum cost difference over 20 years: reduces terminal wealth by approximately 18% (assuming 7% gross return).
• 1.5% per annum cost difference over 20 years: reduces terminal wealth by approximately 26%.

These calculations assume the active fund delivers the same gross return as the passive. If the active fund underperforms gross of fees (which SPIVA suggests most do), the terminal wealth gap is larger still.

For international investors, additional platform costs on active funds, potential non-reporting fund complications, and FX conversion costs on foreign-currency active funds can increase the total cost advantage of passive strategies further.

Factor ETFs: The Middle Ground

Factor investing provides a systematic alternative to the binary active/passive choice. Factor ETFs are designed to capture specific return premia — value, quality, momentum, low volatility, size — that academic research has identified as having historically delivered excess returns above the market.

Key characteristics of factor ETFs:

• Systematic, rule-based selection: Unlike active management, factor ETF holdings are determined by a transparent, publicly disclosed methodology. No discretion; no manager risk.
• Low cost: TERs for factor ETFs are typically 0.15–0.40%, compared to 0.75–1.5% for equivalent active funds.
• Transparency: Holdings are disclosed regularly; the factor exposure can be verified.
• Diversified factor implementation: Smart beta ETFs typically hold hundreds of stocks, maintaining broad diversification within the factor tilt.

The main risk of factor ETFs: factors can experience prolonged periods of underperformance. The value factor underperformed from approximately 2007–2020 before recovering. Investors in value ETFs needed 13 years of patience to see the evidence-based expectation vindicated. Commitment to a factor strategy requires genuine conviction and a long time horizon.

The Core-Satellite Portfolio Approach

The core-satellite approach is a pragmatic framework that incorporates the evidence on passive investing while preserving the ability to make active decisions where they may add value:

Core (60–80% of the portfolio): Low-cost, broadly diversified index ETFs providing beta exposure to global equities, bonds, and real assets at minimal cost. The core is designed to track the market efficiently and is rarely changed.

Satellite (20–40% of the portfolio): Active positions where there is a specific, credible case for differentiated returns:

• Active exposure to emerging markets or small-cap equities
• Factor ETF tilts (value, quality, momentum)
• Specialist active managers with demonstrable long-term track records
• Alternative asset classes (PE, hedge funds, infrastructure) where passive exposure is not meaningful

The satellite is managed more actively, with higher turnover and more frequent reassessment of manager quality and factor positioning.

Evaluating Active Managers: The Practical Checklist

For international investors selecting active managers for satellite allocations:

1. Net-of-fees performance vs benchmark: Evaluate performance after all costs, against an appropriate benchmark. Beware of cherry-picked time periods or unusual benchmarks that flatter the manager.
2. Risk-adjusted return: Sharpe ratio (excess return per unit of volatility) and maximum drawdown provide context alongside raw returns.
3. Active share: The proportion of the portfolio different from the benchmark. Low active share (below 50%) suggests closet indexing.
4. Process stability: Has the investment philosophy and process remained consistent? Manager changes and strategy drift are warning signs.
5. Team stability: Key person dependency — if the named manager leaves, the track record may not persist.
6. Track record length: A minimum of 7–10 years including at least one full market cycle is appropriate. Short track records have low statistical significance.
7. Fund size: Excessive assets under management can compromise the strategy, particularly for small-cap or concentrated managers.
8. Reporting fund status: For UK taxpayers, check reporting fund status before investing.

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This guide is for general information only and does not constitute regulated investment advice. The value of investments can fall as well as rise and you may get back less than you invest. Past performance is not a guide to future returns, and past outperformance by a manager does not predict future results. Tax treatment depends on individual circumstances and the laws of multiple jurisdictions, which may change. Always seek independent regulated advice before making investment decisions.

How Global Investments can help

Global Investments takes an evidence-based approach to active versus passive investment selection. We use low-cost passive ETFs as the foundation of client portfolios and apply active management selectively — in markets where the evidence supports it and where we have high confidence in manager quality. We help international investors avoid high-cost closet indexers and focus active budget on areas where it can genuinely add value. Contact us to discuss portfolio strategy.