A Case for Active Management in an Increasingly Passive World

The debate between advocates of active and passive investing has dominated financial discourse for decades. Each camp promotes (rather dogmatically at times) their investment approach as the better path to portfolio success. All debate aside, however, the industry is clearly trending in one direction - the amount of passively managed assets has swelled since 2012, now accounting for nearly 60% of total U.S. equity fund holdings (or over 50% globally).ⁱ This trend is unlikely to reverse course any time soon, but asset flows alone do not tell the entire story. Despite the very real power of low-cost, passive indexing, claims regarding the eventual decline of active management may overstate the simplicity of the debate. More importantly, for investors holding a globally diversified portfolio, the decision between active and passive investment is not as black and white as some investment professionals attempt to make it out to be.

Setting the Stage

Before we attempt to assess the state of the industry and shed some light on how to think about the active/passive debate, we need to set the stage with a few disclaimers and definitions:

Defining the Terms: Our discussion will primarily revolve around the active/passive debate at the fund level, meaning whether to choose an active or a passive option to gain exposure to a specific asset class (i.e., U.S. large cap, mid-cap, emerging markets, corporate bonds, etc.). Additionally, we will avoid discussion of so-called “hybrid” products that blur the line between active and passive management (such as smart beta products or anything else that is “mostly indexed”). For our purposes, we will define active management as the pursuit of above-index returns (more accurately, returns above a passive investable option) through security selection and position weighting decisions. This is sometimes called “alpha” by investment professionals.

Literature and Data Gaps: There is no shortage of top caliber academic literature on this topic.  Having said that, there is a lack of consistency in benchmarking, and more importantly, the measurement of active performance. The key industry reports that regularly measure relative performance and generally serve as the cornerstone for much of the commentary on this issue - Morningstar’s Active/Passive Barometer and the S&P Indices Versus Active (SPIVA) scorecard - also suffer from methodological shortcomings that necessitate a careful interpretation of their findings. However, despite these shortcomings, these reports can still provide valuable insight and will be referenced throughout the following sections.

Theories of Active Management

All economic analysis (or any analysis for that matter) should begin with a question grounded in common sense and solid reasoning. Otherwise, whatever data collected could easily lead you astray. So, before we look at a single relative return chart, we must ask ourselves, “Does it even make sense for active management to work?”  

“Not at all and it is silly to say otherwise,” claimed Nobel laureate economist William F. Sharpe in one of the most famous papers on the topic.ⁱⁱ And his argument is quite seductive in its simplicity – it is nothing more than the cold hard calculus of market returns. If passive investors hold all the securities in an index at the same weights as the index, they earn the gross (before fees) market return. Active investors, who are simply deviating from those market weights, must also end up holding the index in aggregate – some will just be overweight certain securities and underweight others (they must be held by someone, of course). It follows quite easily then that if active investors hold the index in aggregate, they also collectively earn the same market return as passive investors.  And since we know that active management comes with additional costs, primarily the investment management fee, it surely must be a losing proposition. However, much of this specific argument rests heavily on the “average” active investor and conceptually allows for the possibility of  some outperformance at the expense of laggards, a point to which we will return later.

You can also argue against active management more conceptually. For example, many people accept the theory that markets are highly efficient, meaning simply that security prices do a very good job of incorporating new information quickly. If we assume that all public information is already reflected in a security’s price (which is referred to as the semi-strong Efficient Market Hypothesis), there is simply nothing that can be gained through any fundamental research by an active manager – no individual can “beat” everyone else based on the same information, in other words. By extension, the same theory suggests that security prices follow a “random walk” day-to-day, reacting only to changes in earnings growth or interest rates, and therefore attempting to predict their movement must surely be a fool’s errand.

But market efficiency itself raises an interesting issue. If new information is to be incorporated into prices, it assumes an incorporator – someone who must weigh the importance of the new information and act on it to drive market prices towards whatever new equilibrium is appropriate in that instance. And given that new information is almost always flowing, that market equilibrium is always shifting. That implies that an efficient market, like an equilibrium, is something that we can only get near, but never fully attain.  

Of course, the information being publicly available does not reduce this burden. Indeed, this was the great insight of the forefather of fundamental analysis, Benjamin Graham, who wrote a tome on the importance of balance sheet analysis for stock valuation. At the time, balance sheets were obviously public information, but until someone took advantage of the insights found in them, it was hard to argue that their impact on stock prices had been fully realized. Does that mean markets were not efficient? Perhaps that is an overstatement, but if anything, it does allow for the belief in efficiency while also recognizing that markets may not be fully efficient at all times, and as we will discuss below, in all markets. Someone must do the work to make them so. It brings to mind the old joke:

A new economist and an old economist are walking down the street, and the younger exclaims “Look! There's a $100 bill on the ground!” “Nonsense,” says the older. “If there were a $100 bill on the ground, someone would have already picked it up.”

Markets become efficient because inefficiency (and new information) is capitalized on, not because of chance or some automatic process. If the market were filled entirely with those who passively assumed that the work had already been done, the ground would be littered with proverbial $100 bills...but nobody would bother looking down to pick them up.

From that perspective, it seems obvious that an efficient market requires both passive and active participants.ⁱⁱⁱ And if that is true, it seems rather logical that a performance benefit may be gained by some of those who choose to do the work of seeking an informational edge. 

Active Management in Practice

When we examine relative performance between active and passive funds, this is exactly what we see (Figure 1). Historically, a portion of active managers – albeit one that varies widely - has outperformed passive alternatives over certain periods and in some asset classes. This lends some credence to the idea that while the average active manager may not always win out, some portfolio managers are rewarded for deviating from the index.

You can argue about how rosy of a picture this paints for the active management industry, but for the purposes of this discussion, we are not interested in any individual relative performance figure in the chart. As with all statistics, you can squabble, as many have, over how these numbers were calculated by debating how fees are incorporated or how survivorship bias is handled.^iv Instead, we want to highlight two key trends that appear when you take a wider view of the data:

• First, there is a wide dispersion of active manager outperformance across asset classes. For example, while active managers appear to have a quite difficult time competing within U.S. large cap stocks over longer time periods, as you move down the chart into other market caps, other countries, and eventually into bonds and real assets, the proportion of active managers that outperform seems to grow considerably. And even within market segments, you also see a sizeable divergence between investment factors, like value and growth.    
• Second, even in a market segment in which it has proven notoriously difficult to actively outperform - U.S. large cap stocks - there is considerable volatility in the proportion of active outperformance from year to year (Figure 2).   

Now, while you can of course chalk some of this data up to luck (the joke about monkeys and dartboards comes to mind), the observed asset‑class differences and variations in relative performance across time periods seem at odds with Sharpe’s ‘market math’ and arguments for market efficiency. So let us not linger too long on the question of if active management can work and instead move on to the much more interesting question of why that is sometimes the case.

Potential Drivers of Active Performance

Attempting to explain why active managers may sometimes outperform their passive competition is not so different than trying to explain general market behavior – difficult if only because it is near impossible to imagine, much less measure, everything that could potentially impact outcomes. Instead, we make observations based on reasonable assumptions that, while not exhaustive and certainly not perfectly causal, provide a useful framework for studying markets.  To that end, what we want to highlight here is not that a certain variable will lead to X% of active manager outperformance, but simply that there are numerous variables that can have an impact, and by extension, that the active/passive relationship is anything but stagnant.  

Market Cycles and Dynamics

Active performance seems somewhat cyclical, so what better place to start our analysis than in equity market cycles themselves. It seems logical that a strong bull market, often accompanied by positive (sometimes alarmingly so) investor sentiment and an optimistic business outlook, would prove difficult for an active manager. In these environments, it often feels like the rising tide of a bull market is lifting all ships, severely blunting the active manager’s key edge, which is stock selection. But while long-term bull markets tend to make investors forget that bears exist, corrections are inevitable. And when they eventually happen, they can sometimes lead to a divergence between active and passive performance. This can be for technical reasons, simply following from the fact that fund-level risk management may limit how much of a stock or sector a fund can own. Some may come from the various active bets that managers make in their attempt to deviate from the index. There can also be fundamental reasons for differences in down‑market results, as active managers may adjust their holdings based on their assessment of prevailing market and economic conditions — decisions that can contribute positively or negatively depending on how those assessments play out. We explore this further in the next section when discussing economic cycles and sector weightings.

But high-level market cycles are only part of the discussion – perhaps only a small portion. What truly seems to drive the cyclicality of active performance are the dynamics at play inside the broader market. For example, market breadth (meaning the number of stocks in the index that are doing well) appears to be a key consideration, as overly-narrow markets like we have seen in the 2020’s with the Artificial Intelligence (AI) boom and the dominance of the “Magnificent 7”^v allow little room for active managers to find value. If only a single theme is working, a manager must either hold the theme or lose out, with the only way to beat the market being to hold an overweight position in a small number of stocks that already make up a potentially concerning percentage of the market – something that is often not smart, not possible given fund or regulatory restrictions (which require a specific degree of diversification), or simply not useful given their desire to find an edge elsewhere. As markets broaden out, individual company dynamics can again come into play, with winners and losers able to be identified more for what they are doing than simply whether they are AI-adjacent (to cite one example). 2025 was a study in both environments, with the first half being dominated by post-Liberation Day^vi market volatility and the latter settling back into the dominant tech trade.^vii

Macroeconomic Cycles

Economic cycles clearly matter for market performance, as strong economic growth is associated with strong consumer demand, higher expected returns for business investment, and positive earnings outlooks. As such, business cycles – the ebb and flow of expansion to recession – matter to this conversation to the extent they drive market cycles.

But even just the existence of business cycles presents an opportunity for active managers when it comes to identifying the most promising market sectors.  Each segment of the cycle is traditionally associated with certain market sectors that tend to outperform at various points within an overall cycle. These tendencies are mostly the result of prevailing market sentiment, financial conditions, and quite frankly, textbook-level heuristics. For example, sectors such as energy, technology, and consumer discretionary stocks are often seen as “cyclical,” and are typically expected to do well when the economy expands. Alternatively, things like consumer staples, utilities, and healthcare are seen as more “defensive,” outperforming during economic slowdowns. These are, of course, broad generalizations, and even accounting for how difficult it is to gauge the exact state of the economy at any given moment, these sectors do not always behave according to these rules of thumb. That said, the idea that an active manager would have the ability to shift allocations – to go defensive or offensive – based on their view of prevailing economic conditions, general risk levels, or even an analysis of a policy stance clearly has some merit.   

Monetary Policy

This framing of the impact of business cycles also drives how we think of monetary policy in the active/passive debate. As we already alluded to, U.S. business cycles are often primarily a result of Fed decisions, with real shocks playing a more minor role than investors tend to believe. As such, there is not much to add with regard to how active managers may perform in any given policy environment, whether it is expansionary or contracting – it only matters here insofar as it impacts market cycles.  How the Fed conducts its monetary policy and what influences its decision making may offer some additional insight, however.

The Great Financial Crisis (GFC) led to a multitude of changes to the U.S. banking system from which rate serves as the Fed’s primary policy tool to how banks interact with each other. The most impactful outcome of the GFC was the dramatic growth of the Fed’s balance sheet through multiple rounds of quantitate easing (QE), which were necessary to keep the Fed’s new operating system functional. To many market professionals, this willingness to inject large amounts of money into the economy also revitalized the idea of the “Fed Put” - a term coined during the era of former Fed Chair Alan Greenspan – which holds that the Fed will lower rates or inject liquidity in an attempt to prevent major and persistent market declines. Now, whether the Fed actually responds to stock market moves or simply reacts to changes in economic data that also happens to impact stock prices remains up for debate.^viii However, there is no denying that market performance comes up quite often during Fed meetings, and given the fact that asset prices contain massive amounts of information about investor expectations, there may be some merit to the idea that the market is simply another input into the Fed’s decision making process. Given our earlier discussion of how active managers can experience performance outcomes that differ from the broader market during down markets, the presence of a ‘Fed Put’ could represent an additional headwind for active stock selection. That said, markets have certainly taken their lumps over the years since the GFC, and active stock managers have still found periods of outperformance.

But there is a market that the Fed’s post-GFC activities have impacted much more directly – bonds. During multiple rounds of QE over the last decade-plus, the Fed has not purchased all types of bonds equally. For example, after the GFC, a key effort was made to purchase Mortgage-Backed Securities (MBS) from key lenders to free up space for more loan growth to support the housing market. Similarly, the Fed will often adjust its purchases and sales along the yield curve (which can influence intermediate-to-longer-term yields). And while today the Fed seems to be actively avoiding further balance sheet expansion, efforts to shrink it will likely see similar discrepancies in what is sold and how fast, especially with the housing market serving as a constant focus of both sides of the political aisle. For active bond managers, these narrower Fed actions may provide an edge when it comes to choosing which parts of the bond markets to over or under allocate towards, something on which a passive fund simply would not be able to capitalize.

The Microeconomics: Government Policy and Interest Rates  

The linchpin of the active/passive debate thus far appears to be the relative importance of company specifics – business activity, industry trends, the types of things that go on balance sheets and that are discussed on earnings calls.  As discussed above, when macro conditions shift and highly correlated trades unwind, differences in outcomes among active managers may become more pronounced. But besides the normal cycles we have already discussed, two key factors are worth considering when it comes to making the business-specific factors shine: federal government policy and interest rates.

While we often think of fiscal policy – taxation and government spending – as similar to monetary policy in that it impacts the economy as a whole, this is not quite accurate. The effective corporate tax burden that a company faces changes based on everything from its size and industry to where it operates geographically. Government subsidies provide massive breaks for those industries lucky enough to receive them (or lucky enough to have strong lobbyists in D.C.), and shifting political winds make for an ever-changing landscape of just who the lucky are (just like with government regulations). Trade policy works in a similar way, with it generally serving to protect domestic industry at the expense of some foreign company. Even during the trade upheaval of 2025, which seemed more universal than usual, carve outs and exceptions for certain industries were obvious – paid for, both monetarily (if we assume revenue was a goal) and economically, by other firms and industries.  Now, we are not here to discuss the efficacy or the politics of any such program – in fact, they do not matter to the active/passive discussion. Rather, the result is the same regardless: policy changes can affect firms differently, often in unpredictable ways, and where there are winners and losers, stock selection can benefit.

The business world runs on credit, meaning access to cheap credit is paramount to growth. Obviously, this means that prevailing interest rates can have a considerable impact on corporate investment and other business decisions. But all balance sheets are not created equal, meaning that higher or lower interest rates have a disparate impact across the economy. As just one example, larger, more established firms may be able to lock in longer-term loans and stockpile cash, insulating them somewhat from rising rates, while smaller firms may be forced to roll over short-term debt, making the impact much more disruptive. This type of disparity can be driven by a multitude of factors, from cash flow and cash holdings to the amount of debt the company already has and how that debt is structured (fixed versus floating rate).^ix Debt dynamics are also strongly industry-specific, meaning that while shifting rates can have an aggregate effect on economic activity, active management may be helpful in identifying companies with a more favorable debt structure.

Asset Classes and Global Markets

As we move down the list of asset classes in Figure 1, we observe a wide range of outcomes for active managers, even over longer periods. In some market segments, historical data shows greater consistency in relative results, but as we will show, this comes down to market-specific characteristics as opposed to any persistent specific manager skill. As we discussed at the outset, the U.S. large-cap space is notoriously difficult for active managers, and for very good reasons. It is widely considered to be one of the most liquid and - since we are focused on price discovery – the most efficient markets in the world. For any given U.S. large cap company, there are dozens, if not hundreds, of analysts covering the stock and actively attempting to arbitrage away any informational advantage. This, combined with the fact that almost every investment account in the world holds the S&P 500 in some form or another, leads to new information being captured quickly by market prices, leaving little room for an active manager to exploit an informational advantage.

But this is not the case everywhere. U.S. small and mid-caps, for example, tend to be more volatile, show a higher dispersion between winners and losers, lower liquidity, and fewer dedicated analysts – conditions that may create opportunity for active managers. Outside of the U.S., the active opportunity set continues to expand. Even in the developed international space (think Europe, Canada, and Japan) that have large, liquid markets, thorough analysis must include the decisions of multiple central banks and fiscal authorities and the numerous complex realties of international economics, like trade flows and currency dynamics. Emerging markets add even more complexity, offering a wide spectrum of regulatory, political, and geopolitical risk that requires considerable specialized expertise to wade through, and by extension, an opportunity for divergent active/passive performance.

Outside the public equity space, the active edge becomes even more apparent. The global bond market is not only considerably larger than that of equities – around $145 trillion compared to $126 trillion – but infinitely more complex.^x Government, corporate, and securitized (bonds backed by a pool of assets, like mortgages) debt all bring their own unique characteristics that can create opportunity before you even consider the nearly incalculable number of potential combinations of maturity length, credit rating, seniority (which determines the order of payment when a company fails), optionality, and a variety of other potential clauses and additions. Additionally, most bonds are owned by a small number of institutional investors, which severely limits the number of active buyers and sellers at any given time – an issue only compounded due to the lack of a formal exchange that represents fair market value at any given time (as exists with stocks with the New York Stock Exchange and others).^xi All of this equals a market that, while large, does not trade like its stock counterpart, meaning that the all-important price discovery mechanism simply does not function as well. So, far beyond what value can be gained by understanding the interest rate environment or monetary policy shifts, active bond managers seek to identify and manage inefficiencies that may arise in the market.    

Conclusion

Passive investing serves a vital role, offering cheap and efficient access to key markets around the world, and making index funds and ETFs strong contenders for inclusion in any portfolio. But markets are endlessly complex and ever shifting, meaning that regardless of the merits of any particular passive strategy, it simply may not be effective (or even possible) to take a truly passive approach to all markets at all times. Markets will continue to cycle, internal dynamics will continue to shift, and if the past year has taught us nothing else, the global economy will forever be anything but simple and stable.

As such, we view active and passive strategies as complimentary as opposed to competing tools when it comes to designing globally diversified portfolios. The question we seek to answer is not which investment style is best, but when, where, and how each can be employed most effectively. In market segments that are highly liquid and efficient, low-cost index exposure may make sense. In other segments, where market structure, liquidity, or simply sheer complexity may create more opportunity, active strategies may be a more practical choice. And in a nod to Sharpe’s argument against the “average manager,” we focus on disciplined investment processes, risk management, and consistency of approach when choosing the latter.

All said, while the industry may continue its trend towards passivity, we believe that active fund managers can still play a role in helping make markets efficient and may find opportunities.

The information was prepared by John Weitzer, Chief Investment Officer, Matt Wiley, Deputy Chief Investment Officer, and Matt Conner, Senior Investment Consultant of First Command. Opinions represent First Command's opinion as of the date of publication and are for general informational purposes only and are not intended to predict or guarantee the future performance of any individual advisor. All statistics quoted are as of the date of this publication, unless otherwise noted. First Command does not undertake to advise you of any change in its opinions or the information contained in this report.

This report is not intended to be a client specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Should you require investment advice, please consult with your financial advisor. Risk is inherent in the market. Past performance does not guarantee future results. Your investment may be worth more or less than its original cost. Your investment returns will be affected by investment expenses, fees, taxes and other costs.

Diversification, asset allocation and portfolio rebalancing do not guarantee a profit or protect against a loss in a declining market. They are methods used to help manage risk. Investment returns and principal value will fluctuate and your investment, when redeemed, may be worth more or less than its original cost. Sales charges and taxes may apply.

Investors should carefully consider the investment objectives, risks, charges and expenses of each fund before investing. This and other important information is contained in the prospectus, which may be obtained by contacting your financial advisor or by calling First Command. Please read the prospectus carefully before investing.

All investing involves risk, including the possible loss of principal. Market conditions, economic factors, and individual investment choices can affect outcomes.

Active investment strategies may involve higher fees and expenses than passive strategies, which can reduce returns over time, and active managers may underperform their benchmarks. Passive strategies are subject to market risk and will generally decline during market downturns.

Any references to market data, historical trends, or third‑party research are believed to be from reliable sources, but accuracy and completeness are not guaranteed. Indexes are unmanaged and cannot be invested in directly. Investors should consider their individual circumstances and consult with a financial professional before making investment decisions.

ⁱhttps://www.ici.org/research/stats/combined_active_index
ⁱⁱhttps://web.stanford.edu/~wfsharpe/art/active/active.htm
ⁱⁱⁱhttps://www.aeaweb.org/aer/top20/70.3.393-408.pdf
^ivhttps://www.investmentadviser.org/wp-content/uploads/2021/12/WP_Rethinking_Survivorship_v2.pdf
^vThe name given to the seven large-cap tech stocks that dominated U.S. markets from 2023-2025 (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla).
^viPresident Trump’s sweeping tariff proclamation on 4/2/2025 which resulted in higher market volatility and elevated trade and economic policy uncertainty.
^viihttps://www.spglobal.com/spdji/en/documents/spiva/spiva-us-mid-year-2025.pdf
^viiihttps://www.richmondfed.org/publications/research/econ_focus/2023/q1_federal_reserve
^ixhttps://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/dbtfund.html
^xhttps://www.sifma.org/research/statistics/fact-book
^xihttps://www.sciencedirect.com/science/article/abs/pii/