An institutional client is evaluating two fund managers: Manager A, an active manager, has consistently delivered returns 1% above their benchmark (net of fees) over the past five years. Manager B, who runs an index fund mirroring the same benchmark, charges significantly lower fees. Assuming identical benchmark risk, which statement about comparing active vs. passive management is most relevant?

Question: An institutional client is evaluating two fund managers: Manager A, an active manager, has consistently delivered returns 1% above their benchmark (net of fees) over the past five years. Manager B, who runs an index fund mirroring the same benchmark, charges significantly lower fees. Assuming identical benchmark risk, which statement about comparing active vs. passive management is most relevant?

Answer options:

• Manager A's alpha indicates superior skill, justifying the higher fees.
• Manager B's lower fees will always result in a higher net return over the long term. ✅ The decision depends on whether Manager A's outperformance is sustainable and predictable.
• Active management is inherently riskier than passive management, regardless of returns.

Correct answer: The decision depends on whether Manager A's outperformance is sustainable and predictable.

Explanation: While Manager A has outperformed, the key question for an institutional client is the sustainability of that outperformance after fees. Consistent alpha is difficult to achieve, so the client needs to assess if Manager A's skill is repeatable or if the outperformance was merely luck, making the sustainability a critical factor.