That’s a loser’s game if I ever saw one. But something about these results doesn’t add up.

The degree of recent S&P 500 outperformance hides an important first principle: it shouldn’t be this hard. Like the croupier in a casino, the index should win – but only by a little. If the dealer won 90% of every blackjack hand dealt, no one would play.

Something else is going on.

Why is Active Management Losing So Badly?

I can think of three broad explanations for severe active manager underperformance:

1. Costs.  Fees and transaction costs are a tax on active manager performance. This ever-present reality is a headwind for active managers.
2. Paradox of skill.  Michael Mauboussin refers to an irony that some games get harder to win when the skill of the players increase As professional investors have gotten smarter and less sophisticated investors move into index funds, it is harder for the pros to win.
3. The Index is Winning. We think of an index fund as winning by not losing, but what if the index fund is just plain winning?  

Let’s break down each. 

1. Costs are a toll paid by investors:the higher the cost, the larger the toll. Yet the cost of active management is lower than ever. According to Morningstar, the annual asset-weighted average management fee paid to active managers fell from approximately 1.0% in 2000 to 0.6% in 2024.[4] Similarly, transaction costs are lower than ever. Commissions are close to zero and bid-ask spreads are minuscule thanks to decimalization and high-frequency trading.So shouldn’t active managers be losing by less than they did in the past?

2. Herds of intelligent, motivated, highly compensated professionals have flowed into the investment profession. Charley Ellis cites the increase in CFA Charter holders as a proxy for competition.[5] For sure, active managers are better trained and have access to more information faster than ever before. As the theory goes, fund flows into index funds may have removed many unsophisticated investors from the market, leaving professional investors to duke it out for alpha.

   That theory jumps to a conclusion that ignores other effects of greater manager skill. If investors are better at security analysis, prices should fluctuate less and converge closer to intrinsic value. Yet the opposite has happened. Single stock volatility currently sits in the top 3% of its historical range.[6] Sectors are also moving around more violently than in the past.[7] Retail investors are often the driver of incremental stock price movement, as seen most prominently in meme stocks. If the professionals truly price securities and risk better, they should be able to exploit this volatility.

   The paradox of skill is a compelling narrative, but it is far from a definitive explanation for aggregate active manager underperformance.

3. That leaves a third possibility: the S&P 500 has been winning precisely because of its active characteristics. Concentration in the S&P 500 has been on the rise, with market leading companies dominating economic growth, profits, and performance.

We don’t need to make a pejorative statement that the S&P 500 is too concentrated, carries excess risk, or is poised for a meltdown. It is important instead to recognize the constitution of the index today and rethink what that means for portfolio construction and performance measurement.

Rethinking Portfolio Construction

Throughout most of my career, the S&P 500 has been an appropriate bogey to assess manager performance. It is not today. Equity market exposure should provide broad-based, diversified, liquid exposure to economic growth. Today’s S&P 500 ignores most sectors in the economy, while favoring sectors that have been winning and are highly exposed to the future of AI.

If the S&P 500 is winning because of an implicit active bet, investors should think carefully before accepting the index as their passive exposure. There is nothing wrong with accepting this risk if it is intentional. 

Blindly using the S&P 500 to measure performance is also problematic. Almost every use of the word “alpha” pays little attention to the beta being used for comparison. Governance boards assess performance based on benchmarks, and the S&P 500 has long served as the implicit benchmark for just about everything.

Shifting benchmarks is never a good look, as it leaves an investor exposed to the perception of playing games to justify underperformance. But this is a rare instance where allocators and Boards need to rethink their long-held governance structure.

David Swensen called diversification the only free lunch in investing. In today’s equity markets, diversification no longer resides in the cap-weighted S&P 500. Low-cost, passive investing is a great approach for many investors, most of the time. The majority of active managers simply won’t win. But unlike over the last decade, many active managers will win.

Leading CIOs are thinking deeply about this problem. I have spoken to several who cite diversification as a rationale for active management in both public and private markets – something I have never heard before. Active management defined broadly can mean index fund selection, factor ETFs, or the selection of an active manager. It is not, however, a default to the S&P 500. 

The rising tide of the S&P 500 may have peaked, as the equal-weighted S&P 500 bested the cap-weighted S&P 500 by 7% in January and February, a gap not seen in 17 years. Investing from first principles calls for allocators to rethink their use of the S&P 500 index, both as a passive vehicle and a benchmark for success.