The goal of actively managed funds is to generate alpha - returns above the appropriate risk-adjusted benchmark. We might add here that the alpha should also be sufficient to compensate for the increased idiosyncratic risks active managers take by failing to fully diversify, and that the only way to generate alpha is to hold a different/less diversified portfolio than the benchmark.
As economist William Sharpe pointed out in his famous paper, "The Arithmetic of Active Management," before costs active management is a zero sum game, and after costs it's a negative sum game: "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement." In other words, for active managers to be successful they must have victims that they can exploit. Who exactly are these victims?
The evidence is that they are likely to be individual investors. The research, including a series of studies by Brad Barber and Terrance Odean, has found that, in aggregate, individual investors around the globe underperform standard benchmarks, such as low cost index funds, even before costs or taxes. When individual investors trade, they are exploited by institutional investors. And while there's a wide dispersion of results among individual investors, even the best traders have a hard time covering costs. Interestingly, Barber and Odean have found that not all of the underperformance can be attributed to the excessive trading done by individual investors. On average, individual investors have perverse security selection abilities - they buy stocks that earn subpar returns and sell stocks that earn strong returns.
Since alpha is a zero sum game - if there are losers (even before costs), there must be winners - who are the winners? The winners are institutional investors, such as actively managed mutual funds. The research shows that on a gross return basis, active fund managers are able to generate alpha, exploiting the bad behavior of individual investors. For example, Jonathan B. Berk and Jules H. van Binsbergen, authors of the 2013 study "Measuring Skill in the Mutual Fund Industry," found that the average mutual fund has added value by extracting about $2 million a year from financial markets, and that value added is persistent for as long as 10 years. They concluded: "It is hard to reconcile our findings with anything other than the existence of money management skill."
The study "Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses," by Russ Wermers, published in the August 2000 issue of The Journal of Finance, provides further evidence of stock-picking skill. Wermers found that on a risk-adjusted basis the stocks active managers selected outperformed their benchmark by 0.7 percent per annum.
However, investors earn net, not gross returns. The studies have also found that expenses have more than eroded the benefits from stock-selection skills, leaving investors with net negative alphas. In other words, "economic rent" goes to the scarce resource (the ability to generate alpha) not to the plentiful resource (investor capital), just as economic theory predicts. While active institutional investors have been able to exploit the bad behavior of individual investors, fund sponsors have been the winners, not investors in the funds.
Making matters worse is that the trends are working against active institutional investors, and individual investors as well. As Roger Stambaugh points out in his January 2014 paper, "Investment Noise and Trends," there's has been a substantial downward trend in the fraction of U.S. equity owned directly by individuals. At the end of World War II, households held more than 90 percent of U.S. corporate equity. By 1980 that fraction had fallen to 48 percent. It fell again - by more than half - by 2008, dropping to about 20 percent. The financial crisis certainly did nothing to alter the trend. The result is an ever shrinking pool of victims that can be exploited.
At the same time, the pool of dollars seeking to exploit pricing mistakes has increased dramatically. For example, in less than 10 years the amount of capital invested in hedge funds has increased from about $1 trillion to more than $2.5 trillion. With institutional investors now doing as much as 90 percent of the daily trading, exactly who are the victims these sophisticated investors are going to exploit in their quest for alpha?
Even within the institutional space the availability of victims to exploit is shrinking. Stambaugh notes that 25 years ago almost all mutual funds were actively managed. Today, index funds account for almost 20 percent of the industry, and their share is persistently growing. He also notes that the fraction of institutional assets in passive funds is growing even faster. By 2006, the percentage of institutional assets in actively managed funds was already below 60 percent.
One logical explanation for the more rapid decrease in the active share of institutional investing is that institutional investors are more likely to be aware of the academic literature demonstrating how difficult a game active management is to win. Another possible explanation is that they are also aware that the pool of victims available to be exploited is rapidly shrinking, raising the hurdles for successful active management.
For individual investors who recognize that active management is a loser's game - a game that's possible to win, but with odds so low that it's not prudent to try - the trends are all favorable. For example, individual investors are benefiting from the intense competition between providers of passively managed funds. Competition from the many providers of ETFs, with their lower costs, has been driving expense ratios persistently lower. There are now many index products with fees in the single digits. For example, the Schwab U.S. Broad Market ETF (NYSEARCA:SCHB) has a net expense ratio of just 0.04 percent.
The trend to lower expenses is making passive investing even more of a winner's game. And that is contributing to a virtuous circle - lower costs are helping drive more investors to become passive, shrinking the pool of victims that can be exploited, and raising the hurdles for the generation of alpha.
There's another insight that we can draw from this trend. It seems likely that those abandoning active management in favor of passive strategies will be investors who have poor experiences with active investing. Thus, it seems logical to conclude that the remaining players are likely to be the ones with the most skill. (If investors' outperformance was based on luck it will eventually disappear and they will abandon the game.) As less-skilled investors abandon active strategies, the level of competition among the remaining investors increases. Unless you happen to be Warren Buffett, the winning strategy is to not play. Instead, accept market returns in the asset classes in which you choose to invest.
While we recognize the benefits of passive investing, it's important to point out that active managers play a very important societal role - their actions determine securities prices, which in turn determines how capital is allocated. And it's the competition for information that keeps markets highly efficient in terms of both information and capital allocation. Passive investors are "free riders." They get all the benefits from the role that active managers play in making the financial markets efficient without paying any of the costs. In the end, passive investors do need active investors to keep transaction costs down and the markets informationally efficient.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.