On the first few trading days of every month, America’s paychecks hit the stock market. Most 401(k) contributions now default into index-tracking funds, which buy the same stocks in the same proportions whatever the price. New research shows this tide measurably lifts the funds that hug the index and sinks the managers who dare to deviate from it; a few basis points at the turn of each month, every month, for 15 years running.
The paper, “Passive Flows, Active Woes” by Hannah Unterberg of the University of California at Irvine, documents something stranger than the familiar complaint that active managers can’t beat the market. From 1984 to 2009, the average US active equity fund lagged behind its risk benchmark by 0.72% a year — roughly its fees, which is what an efficient market should deliver. After 2010, the shortfall widened to 1.82% even as fees fell. Weighted by assets, active funds now lag the market by 0.81% a year before fees, something that, statistically speaking, never happened in the prior quarter-century.
Stranger still, the relation between activeness and performance flipped. “Active Share” (the fraction of a portfolio that deviates from its benchmark) predicted outperformance for decades, and the funds that deviated most beat the closet indexers by 0.85% a year before fees. Since 2010, though, they’ve trailed them by 1.11%.
See more: The Mega-cap IPOs’ Impact on Index Funds
Fading anomalies are routine in finance; reversals are not. If markets simply got more efficient, or if everyone read the Active Share papers and competed the edge away, the premium should shrink toward zero, not turn against the skilled.
Unterberg’s explanation for the reversal is flows. When investors pull money from an active fund, the manager must sell what he or she owns - the overweights, the best ideas. When that money migrates to an index fund, it buys benchmark weights instead. Repeat with $3 trillion over 15 years and you get relentless selling pressure on exactly the stocks active managers favor and relentless buying of whatever dominates the index. Unterberg estimates each percentage point of flow-driven demand moves fund returns by two to three points.
Crucially, that pressure from passive flows doesn’t wash out. Half of it is still in prices three years later. Sharp investors trade against short-term selling pressure, but no one has the patient capital to trade against a generational structural shift.
When I asked Unterberg about the obvious objection — that the past 15 years were simply the megacap decade, and stock-pickers structurally underweight the giants, she pointed out that the underperformance shows up where megacaps can’t reach. “I wouldn’t expect megacap exposure to drive the underperformance we see in active small-cap funds,” she told me.
This is just a bubble, just slower and quieter than most. Inflows push up index funds and depress active funds; this pushes down the stocks active managers favor and pushes up the stocks they dislike; index outperformance drives the next round of flows. Index funds’ returns are, in part, bought with their own investors’ money.
The loop accelerates in that every dollar that leaves active management shrinks the pool of price-sensitive investors who might lean against the tide, so each new dollar of flow moves prices more.
By William Sharpe’s famous arithmetic, the value-weighted average active dollar must earn the market return before costs. For every overweight there is an underweight. Gross alpha sums to zero. Through 2009 the data obeyed. Since 2010, with active mutual funds lagging the market by 0.81% a year before fees, someone outside the fund industry is collecting on the order of $50 billion a year. Who? Unterberg pointed me to new research by Marco Sammon and John Shim, forthcoming in the Review of Financial Studies, that identifies the marginal sellers to index-fund buying: the companies themselves, supplying shares almost one-for-one through stock-based compensation, share issuance and curtailed buybacks. The winners, in other words, are companies and their insiders, selling stock to your 401(k) at prices the index’s own buying inflated.
The index revolution was sold as the small investor’s revenge on Wall Street. Through the flow channel, its great beneficiaries seem to be corporate insiders, and, as Unterberg allows, perhaps the fast-money traders who intermediate the flows, whom quarterly holdings data cannot see. The fees got democratized; the alpha got aristocratized.
How does it end? Every bubble stops when the flows do. But this one carries almost no leverage — margin debt and leveraged exchange-traded funds total roughly 2% of the market, and little of that sits behind index funds — so there is no margin call, no pop. It leaks, starting when boomer contributions give way to required minimum distributions. Then the machine runs in reverse, and outperformance attracts flows to active funds again.
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