Index funds make active managers worse

‘Blame it on the index funds’ is a popular game when it comes to analysing market concentration and the extreme valuations of US megacaps. But apparently, the rise of index funds has also made active managers worse.

Index funds have become the dominant investment vehicle in the US by now. At the end of 2024, passive funds accounted for 20% of US stock market capitalisation while actively managed funds stood at 12%. Passive funds in the US surpassed active funds in assets under management in 2020. The outflows from active funds in the US have been relentless and pretty much nonstop since 2008.

Cumulative flows for US equity funds

Hannah Unterberg from UC Irvine examined whether this shift toward passive investing has impacted the performance of active funds. There are some theoretical arguments that say that if there are fewer active managers, the market should become less efficient and thus it should be easier to generate outperformance. Also, in theory, if active managers face outflows, the underperforming managers should be more likely to close their funds and the better-performing managers should get a larger share of the active fund management market.

In theory. As you know, I don’t discuss theories in these missives. Truth is what works, not what some economists decide should happen based on their paper models.

And indeed, rather than increasing their alpha, Unterberg’s analysis shows that the four-factor alpha of active funds (both gross and net of fees) went through a regime shift and started to decline significantly in 2010 or so.

The charts in the bottom row below (alpha gross of fees) are particularly striking. Gross of fees, active funds showed positive alpha until 2010 (a rising trendline) and negative alpha afterwards (a falling trendline). And the effect is apparently larger for funds with a higher active share and more concentrated portfolios.

Risk-adjusted returns of active funds

The big question, of course, is whether this is just spurious correlation or whether there could be causation. Unterberg’s research doesn’t prove causality, but she does have some suggestive results. What seems to happen (or at least contribute to the effect) is that the rise of index funds creates flows that work against the active tilts of active funds.

Imagine you are an active manager who is overweight some stocks and underweight others. Because of the shift from active to passive, you are facing net outflows, which force you to sell some of your holdings. These holdings get invested in passive funds that track the benchmark. Now let’s look at stocks that you are underweight in your active fund. You sell these stocks, and the passive fund invests in the same stocks. But because you are underweight vs the benchmark, the passive funds buy more of that stock than you sold. The net effect is additional buying pressure on the stock you are underweight.

Now look at a stock that you hold at an overweight vs benchmark. You sell those stocks, and the passive fund buys the same stocks. But the passive fund in this case buys less of that stock than you sold. The net effect is additional selling pressure on that stock from the shift to passive.

You see how every time an active fund faces redemptions, there is net flow pressure in the opposite direction of the fund’s active tilt. And funds with larger active shares face stronger flow pressure.

The effect is small for every individual fund and each individual month, but add it up for many months and across many funds, and you get a systematic drop in alpha from these flows alone.