Market Valuation Sustainability and the Active vs. Passive Dilemma: A 2023–2025 Perspective

The debate between active and passive investing has long centered on market efficiency, fees, and the ability of active managers to generate alpha. However, the 2023–2025 period has brought this discussion into sharper focus, particularly amid stretched market valuations. As equity markets reached historic price-to-earnings ratios and dispersion among stocks narrowed, the performance of active funds relative to passive benchmarks has revealed critical insights into the sustainability of current valuations and the role of active management in navigating them.

The Passive Dominance in Large-Cap Equities

According to a report by MorningstarMeasuring the Performance of Active Funds Against …^[1], the underperformance of active large-cap funds has been stark. In 2024, only 37% of active large-cap funds outperformed their passive peers, with large-growth funds showing a 40% success rate—up from 20% in 2023—while large-value funds saw a significant drop in performanceMeasuring the Performance of Active Funds Against …^[1]. Over the 10-year period ending in 2024, passive large-growth funds outperformed active ones by 2.3 percentage points annually, and passive large-blend funds had a 1.7-percentage-point advantageMeasuring the Performance of Active Funds Against …^[1]. These trends underscore the challenges active managers face in highly efficient markets, where stretched valuations leave little room for error.

The SPIVA 2024 reportActive funds versus passive indexes: the latest scorecards^[3] corroborates this pattern, noting that even in bond markets, where active strategies historically have had more room to maneuver, only 36.7% of active intermediate core bond funds outperformed passive benchmarks over 10 years. This suggests that the penalties for poor stock or bond selection in efficient markets—where mispricings are rare—tend to outweigh the rewards for correct choicesActive funds fell short of passive peers in latest^[2].

The Small-Cap and Mid-Cap Exceptions

While large-cap equities tell a story of passive dominance, small-cap and mid-cap categories offer a more nuanced picture. In 2024, active small-cap funds had a 43% success rate, and over the 10-year period, 43% of active small-cap strategies outperformed their passive peers—compared to just 26% for large-cap strategiesMeasuring the Performance of Active Funds Against …^[1]. Mid-cap active funds, though showing a decline in 2024, still achieved a 37% success rateMeasuring the Performance of Active Funds Against …^[1].

This divergence highlights the importance of market efficiency. Smaller-cap stocks, often less followed by analysts and more prone to mispricing, create opportunities for skilled active managers to add value. As stated by MorningstarMeasuring the Performance of Active Funds Against …^[1], the cyclical nature of active and passive investing becomes evident here: in less efficient markets, active strategies can capitalize on dispersion, whereas in efficient ones, passive approaches dominate.

The Fee Factor: A Hidden Determinant of Success

A critical but often overlooked aspect of active management is the role of fees. Data from Morningstar's 2024 reportActive funds versus passive indexes: the latest scorecards^[3] reveals a consistent pattern: lower-fee active funds outperformed higher-fee ones over the 10-year horizon. For example, in U.S. large-cap value, the lowest-fee active funds had a 19.1% success rate compared to 13.2% for the highest-fee fundsActive funds versus passive indexes: the latest scorecards^[3]. This trend was evident across other categories, including U.S. large-cap growth and U.S. small-cap valueActive funds versus passive indexes: the latest scorecards^[3].

The fee-performance relationship underscores a broader truth: in markets where active management is already a losing proposition, high fees compound the problem. Investors seeking active strategies must scrutinize cost structures, as even marginal fee differences can erode returns over time.

Implications for Market Valuation Sustainability

The 2023–2025 data raises questions about the sustainability of stretched valuations. When markets are overvalued, the margin for error shrinks, and active managers—whose strategies rely on identifying mispriced assets—struggle to differentiate themselves. As noted in a 2025 analysisActive funds fell short of passive peers in latest^[2], the inverse relationship between style benchmarks and active success rates during periods of market rotation (e.g., growth vs. value) further complicates matters. For instance, during 2020–2021, when growth stocks outperformed, only 40% of active large-cap growth funds beat their benchmarks, while 88% of active large-cap value funds didA matter of style: Shifts in active fund performance^[4]. This pattern reversed in 2022–2023, illustrating how style rotations amplify the challenges for active managers in a low-dispersion environmentA matter of style: Shifts in active fund performance^[4].

However, the data also suggests that stretched valuations are not a universal death knell for active management. In fixed income and small-cap equities, where markets are less efficient, active strategies have shown resilience. For example, 26% of bond funds outperformed passive strategies over the past decadeMorningstar: Only 14.2% of active managers beat …^[6], and 53.5% of active bond managers outperformed their benchmarks in Q1 2025Analyzing Q1 2025 active and passive asset classes^[5]. These results highlight the importance of asset-class-specific considerations in evaluating active management's viability.

Conclusion: A Pragmatic Approach to Active vs. Passive

The 2023–2025 period has reinforced the long-term advantages of passive investing in efficient markets, particularly large-cap equities. However, it has also demonstrated that active strategies can add value in less efficient segments, such as small-cap equities and fixed income. For investors, the key lies in aligning strategies with market realities: in a world of stretched valuations and narrow dispersion, passive approaches offer cost advantages and consistency, while active strategies should be reserved for niches where skill can meaningfully impact outcomes.

As markets continue to evolve, the sustainability of current valuations will depend not only on macroeconomic fundamentals but also on the ability of investors to adapt their strategies to the efficiency—or inefficiency—of specific asset classes.