How Passive Investing Is Impacting Active Fund Performance: Implications for Investors

The document discusses the declining effectiveness of active management in mutual funds, particularly since 2010. It highlights various studies that have questioned the predictive power of “active share,” a measure of how much a fund’s holdings deviate from its benchmark, in relation to future performance.

Key Points:

1. Historical Context:

   • Research by Fama and French (2010) showed that only about 2% of active managers outperformed their benchmarks.
   • Cremers and Petajisto (2009) suggested that high active share correlates with better performance, creating hope for active strategies.

2. Subsequent Research:

   • Later studies (AQR Capital and BlackRock) cast doubt on this correlation, finding that after 2010, high active share funds actually underperformed.
   • A significant finding indicated that by 2016, high-active-share funds had a negative alpha.

3. Flow-Driven Mechanism:

   • Unterberg’s 2026 paper introduces a “flow-induced demand” mechanism, indicating that shifts from active to passive funds lead to adverse price pressures on stocks favored by active managers.

Six Key Findings from Unterberg’s Study:

• Increase in Underperformance: Active fund alpha declined markedly after 2010.
• Reversal of Active-Share Premium: High-active-share funds began to underperform compared to low-active-share funds.
• Flow-Induced Demand: The negative return correlation with active share is influenced by fund flows, not by managerial skill deterioration.
• Price Impact Persistence: Passive flows have lasting price impacts, while active flows do not.
• Causality Evidence: Data from 401(k) inflows supports the flow-induced performance changes.
• Industry-Level Effects: A larger passive share correlates with narrower active-minus-passive return spreads.

Investor Takeaways:

1. Active share is no longer a strong predictor of performance.
2. The decline in performance is more about market dynamics than manager skill.
3. Funds deviating most from their benchmarks are most at risk from flow pressures.
4. The current environment may shift if passive fund flows decelerate or reverse.

Implications for Market Efficiency:

1. Less efficient price discovery may arise for stocks influenced by active and passive ownership.
2. The narrative that passive investing makes markets more efficient is challenged.
3. Future pricing dynamics depend on who absorbs the supply-demand imbalances.

In conclusion, the paper interrogates how the rise of passive investing reshapes the landscape of active management, suggesting that the interplay of market structure and investor behavior significantly impacts fund performance and expectations.