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One of the semi-foundational beliefs of many active managers getting pounded by relentless investor outflows is that there’s a “tipping point” where the market inefficiencies caused by passive investing are so bounteous that stock pickers stage a comeback.
Instead, the more money there is in passive funds, the worse average active performance seems to get. Here’s an interesting new paper on how this paradox can be explained:
This paper studies whether the secular shift toward passive investing has affected active fund performance through flow-induced demand effects. Using U.S. equity fund data (1984-2024), I document a decline in active fund performance after 2010, with average annual four-factor alpha falling by around one percentage point and the previously positive relation between Active Share and performance reversing. These patterns contrast with theories predicting improved performance as the active sector shrinks.
A flow-driven framework shows that capital reallocations toward passive funds generate asymmetric price pressure, penalizing funds’ active tilts. Flow-induced demand significantly impacts fund returns, with the effects of passive flows persisting over multiple years. Controlling for flow-induced trading can explain the negative Active Share-performance relationship, suggesting that underperformance reflects structural demand headwinds rather than declining manager skill. Higher-frequency tests exploiting plausibly exogenous, beginning-of-month passive flows provide additional evidence.
Tl:dr, the author — Hannah Unterberg, of the University of California’s Paul Merage School of Business — argues that the shift from active to passive is causing the worsening active performance.
Here’s the rationale: When an investor yanks, say, $1mn from an active fund and plonks it into SPY, the fund manager suffering the withdrawal has to sell some of their existing positions, while the S&P 500 ETF mechanistically invests the $1mn according to the index weights.
That means that the fund manager is selling their favourite stocks — where they are “overweight” in industry parlance — while the ETF buys stocks that they hate (or are “underweight”). This “differential flow-induced demand” essentially keeps pummelling the favoured positions of active managers, while buoying the stocks they don’t like.
As the paper concludes:
When capital shifts toward passive vehicles, the resulting flow-induced demand reduces funds’ relative returns in proportion to their active tilt. Tests exploiting beginning-of-month passive flows provide corroborative evidence and aggregate time-series regressions show that the relationship between industry passive share and the active–passive return spread turned negative after 2010. Taken together, the results suggest that the decline in active fund performance primarily reflects structural demand headwinds from the reallocation toward passive investing rather than a deterioration in manager skill.
This is an interesting, data-driven approach to showing something that some passive investing sceptics have long argued. Unterberg’s paper won the Two Sigma Award for “Best Paper in Investment Management” at the Western Finance Association’s 2026 confab last month.
But Alphaville has some niggly issues with the argument, one specific and one more general.
While the stylised top-level observation — that passive flows are somehow contributing to active underperformance — might be broadly true-ish, it doesn’t seem obvious that active managers will necessarily be paring back their more favoured overweights when they suffer outflows. And as the stock market has once again demonstrated lately, active managers remain the price setters and passive funds the price takers.
More broadly, Alphaville suspects that a better explanation for why active performance has atrophied in tandem with the ascendance of passive investing is something we think of as the Poker Table Theory of investing, inspired by the writing of Michael Mauboussin.
Imagine you’re at a big poker night with your friends, 10 tables of 10 players each. Luck will play a role — as will an ability to buy yourself back in — but over time you’d expect the worse poker players to get wiped out as the night goes on. Eventually, only the 10 remaining players gather around one table to duke it out. But is this game easier because 90 per cent of your competitors have left, or is it harder? It’s obviously harder, because the players that remain will probably be the strongest ones.
Markets function a bit the same way. The emergence and rise of passive have made it harder than ever to be a bad or even mediocre fund manager. Over time they get drummed out, and the survivors — plus the new ones that emerge — have to work harder and smarter than ever before, because their competition is working harder and smarter than ever before.
As Mauboussin argued in Who Is On the Other Side? his recent framework for understanding market efficiency:
To generate excess returns, investors should seek easy games where their skill will pay off. In investing as in poker, the key to winning is participating in a game where there is differential skill and you are among the most skilled players. This is a challenge because investing is generally highly competitive, markets where participant skill is low are often small, and agency costs commonly compel the wrong behaviours.
(Not coincidentally, this is one of the reasons why many fund managers will generally cheer for the “democratisation” of investing and greater involvement from individual retail investors. Your loss is their alpha)
In other words, active management is getting harder because active managers are getting better, and there are simply fewer patsies around the table. This strikes Alphaville as a better overall explanation for the apparent “passive flows, active woes” paradox.
