Bigger index funds make active managers worseIndex funds make active managers worse

After passive funds overtook active ones in the US in 2020, active funds' gross alpha turned from positive to negative around 2010, and a researcher argues that redemption flows pushing against active bets explain part of it.

Blaming index funds is the standard move when explaining silly valuations on US megacaps. Now they have another charge against them: active managers are getting worse.

The money went passive

In 2020 passive funds overtook active ones by assets under management in the US. By the end of 2024, passive held 20% of US stock market capitalisation; active held 12%.

The bleeding out of active funds has been more or less continuous since 2008. You would think fewer active managers means a less efficient market and easier outperformance, and that the weakest managers would be redeemed out of business while the rest got stronger.

That is not what happened

Hannah Unterberg at UC Irvine looked at the four-factor alpha of active funds. It went through a regime shift around 2010 and has declined since.

Gross of fees, alpha trended up before 2010 and down after. Funds with a higher active share and more concentrated portfolios were hit harder.

What you sell, the index buys back

Take redemptions. An active manager has to sell. For a stock the fund overweights, the passive fund buys it too, but only at benchmark weight, so it buys less than was sold, and the stock ends up under extra selling pressure.

For a stock the fund underweights, the passive fund again buys at benchmark weight, which is more than was sold, so that stock gets extra buying pressure. Every redemption pushes against the fund's own tilt.

Small for one fund in one month, but across many funds and many months it quietly eats into alpha. The research stops short of proving causation.