The Four Pillars Explaining Why Active Fund Underperform
Each pillar explains a key reason why active funds, as a group, struggle to match passive investing over time.
The silent killer: fees
Why fees matter
Fees are the biggest reason active funds fall behind. They are not one-off charges but are applied every year on both your original investment and the growth it earns. Over time, these costs compound and steadily erode your returns.
In South Africa, the average passive fund charges about 0.65% a year, while the average active fund charges about 1.35%, as seen in the graph. That gap of just 0.7% may appear small, but over 10, 15, or 20 years it compounds into a significant drag on performance and reduces your final investment value.
If active funds consistently outperformed by that gap of 0.7%, their higher fees might be worth paying. But history shows they do not, and instead those fees steadily eat into long-term gains.
The real-world impact of fees
Numbers on a page can feel abstract, so let us look at a simple example of how fees affect your returns, as seen in the graph.
Suppose you invest R100,000. To keep it straightforward, assume both an active fund and a passive fund earn the same 10% per year before fees. After fees are deducted, here is what you would actually end up with after 20 years:
Passive fund (0.65% fee): about R598,000
Active fund (1.35% fee): about R526,000
Even though both started with the same R100,000 and the same 10% gross return, the higher fees of the active fund leave you with about R72,000 less after 20 years.
The key lesson is simple. Compounding works on gains and on costs, and over time, the gap between active and passive funds grows wider.
2. The Hidden Cost of Trading
While the annual fees discussed above explain much of the difference between active and passive funds, they do not capture the impact of trading costs.
Trading costs occur every time a fund manager buys or sells shares. Active funds rack up these costs because managers trade frequently in an effort to outperform the market. Passive funds, by contrast, simply buy and hold the market, since their goal is only to track the index.
Over time, these trading costs add up just like annual fees. They compound quietly in the background, creating yet another drag on the long-term returns of active investors.
3. The Zero-Sum Game
Imagine the market as one big pot of returns. Together, all active fund managers make up that pot. If the market earns 10 percent, then active managers as a group also earn 10 percent before costs. Some managers will do better and others will do worse, but on average they add up to the market itself.
Here is the problem: it is a mathematical fact that once fees and trading costs are subtracted, the average active fund must fall below the market return.
Passive funds, in contrast, do not compete in this game. They simply copy the market through an index, holding all the shares in proportion to their size, and deliver close to the full 10 percent, reduced only by a much smaller cost.
Over time, those lower costs make all the difference.
This means that, as a group, active investors will always underperform the market after fees are included.
4. Why past winners do not stay winners
Some fund managers may outperform the market for 10 or even 15 years. But when you look at the next decade, there is no consistent link between those who won last time and those who win next.
The winners do not stay winners. The record shows that past performance is no guarantee of future success.
Why any outperformance rarely last.
Competition is fierce: Every fund manager has access to the same information, research, and tools, so any advantage disappears quickly.
Luck runs out: A manager might benefit from a few good bets, but over time they fail to consistently find them, and the bad bets erode the gains.
Costs compound: Fees and trading costs drag results down year after year, eroding any temporary advantage.
Size problem: As a fund grows, it becomes harder to move in and out of positions without influencing prices, making it more difficult to keep outperforming.