The case for active management when so few outperform the S&P 500

One question many are asking after 2025’s continuation of the artificial intelligence-led stock market rally is whether we still need actively managed stock funds.

The relative performance numbers from last year aren’t pretty. According to Morningstar, of the thousands of actively managed U.S. large-cap blend stock funds, an embarrassingly small number of them (27%) outperformed the S&P 500 index in 2025.

And that’s the good news, because the number of actively managed large-cap blend funds outperforming the S&P 500 index in the past three and five years is even lower, at 22% and 16%, respectively.

Cost is one reason so many highly educated and well-paid investment experts are having such a difficult time beating the S&P 500. But the construction of the index itself is another telling part.

The S&P 500 index, like most indexes, is “cap weighted,” which means each holding is weighted based on the market value of its outstanding shares when calculating the index’s return.

In other words, the more valuable the company, the larger its influence. In 2025, less than 5% of the S&P 500’s holdings were responsible for more than 71% of its return.

As investors pile more money into S&P 500 index funds, the cash is invested in the same cap-weighted manner, meaning an increasingly large percentage of incoming cash goes into a handful of already very large technology companies.

The last time the S&P 500 index was this concentrated was in the early 2000s, a period now affectionately referred to as the Tech Stock Bubble.

At their peak, the top-10 companies in the index represented approximately 25% of the index and carried an average P/E of 43. This period preceded a technology stock swoon greater than 70% in a matter of months and serves as a painful reminder of the risk of putting so many eggs into so few baskets.

Today, the top-10 companies represent just more than 40% of the index, but some argue this time is different because their average P/E is “only” 28. I fear many investors don’t fully understand how concentrated their index fund has become and are unaware of the amount of risk they are currently accepting.

Everybody has their own risk tolerance, and it is easy to grow complacent and forget a bull market can cause a virtuous circle, but that can quickly become a vicious cycle of wealth destruction as a bear market causes the rapid selling of a similarly narrow group of stocks.

While the S&P 500 index generally is invested in 500 different companies, the actual list of companies is constantly changing.

This means there is an “active” element to the S&P 500 index. Case in point, when one well-known member of the S&P 500 index, Enron, filed for bankruptcy in 2001, the committee decided to replace it with an up-and-coming video game chip maker named Nvidia. If you’ve had money invested in this index since 2001, you’ve participated in one of the greatest home-run investments of all-time.

History shows the ebb and flow of the relative performance of active managers.

In bull markets, index funds become extremely difficult to beat. In bear markets, what was their strength becomes their weakness, and they become easier to beat.

Today’s S&P 500 index operates at odds with its long-stated objective of offering a well-diversified portfolio, and it should be no surprise the average actively managed fund, which is much more diversified, is lagging. In fact, the only active strategies beating the S&P 500 today are generally those taking even more concentration risk.

In the short term, now might not be an ideal time to overweight indexing given the higher-than-normal amount of risk this strategy currently contains. In the long term, indexing your U.S. large-cap exposure makes sense because bull markets are much more common than bear markets, but only for those willing and emotionally able to suffer through the occasional extreme downside volatility.