I was reminded recently of the (regrettably apocryphal) recipe for rabbit stew which began with the words “First, catch a rabbit.” The reminder came from an article by a leading active management shop, which argued that “the more assets that flow to passive strategies, the more potential alpha there could be for successful active managers.,,, Good active managers will be able to benefit from the migration to passive.” Supposedly, the silver lining in the growth of passive management is that there will be less competition for active returns, and fatter rewards for investors who keep the active management faith.
At a certain level, the argument is tautological. It’s the “successful” and “good” active managers who will supposedly benefit from the growth of passive management. How will we know who they are? By observing, after the fact, which managers outperform their passive benchmarks. But outperformers are always considered “successful” after the fact, regardless of how much or how little competition there is from index funds. Can we identify successful (i.e. outperforming) active managers before the fact?
Doing so requires us to assume that active skill is both present (i.e., that the thing we’re looking for really exists) and persistent (so that historical performance will help us find it). In fact, neither of these things is true. Our SPIVA reports, among others, have long demonstrated that most active managers fail to beat their benchmarks most of the time. And above-average managers in one year have only a random chance of being above average the next year.
But let’s assume, for the sake of argument, that active skill is both present and persistent. If that were true, which active managers would lose assets to index funds? Logically, the growth in passive management should come at the expense of the worst active managers. This matters, because active management is a zero-sum game. I can only be above average if someone else is below average, and the aggregate amount by which all the winners win must be exactly equal (before costs) to the aggregate amount by which the losers lose. So when the worst active managers lose business, the aggregate amount of underperformance falls. Therefore the aggregate outperformance available to the best active managers also falls.
By reducing the assets run by underperforming active managers, indexing reduces the rewards for those who remain. It’s harder than ever to catch that elusive rabbit.The posts on this blog are opinions, not advice. Please read our Disclaimers.