This is the seventh part in a series examining the evidence behind the claim that passive investing is causing a bubble.
For the previous part, on whether passive investing is causing large stocks to get even larger, click here.
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If passives were distorting prices, if dispersion was reducing, and if equity concentration was increasing, it should make it easier for active managers to outperform.
With all those inefficiencies caused by index investors, we should see the percentage of active managers outperforming the index increase as flows into passives increased.
Index investing is a simple, rules-based approach to investing. It’s no secret which stocks index investors are going to be buying, or when. With huge flows going into such a transparent and rules-based strategy, it seems reasonable that if such a strategy were changing the market, active managers would be able to exploit the strategy’s transparency and rules-based approach to increase their chances of outperforming. Which begs the question…
Where are all the outperforming active managers?
The evidence
Some of the first posts I wrote on this blog were looking at the percentage of active managers outperforming the market.
It’s safe to say that if indexing was indeed distorting the market, active managers have failed to capitalise on these inefficiencies. The vast majority of active managers still fail to beat the market.
In the USA, the combination of most active funds failing to survive, combined with most active funds underperforming their benchmark, has meant that fewer than 15% of active funds both survived and outperformed their passive benchmark over the past 15 years.
When adjusting for risk, the results are even worse for US active funds, with fewer than 5% of active funds surviving and outperforming on a risk-adjusted basis.
The table from this post shows that not only has active management done a poor job of protecting investors when markets crash – actives underperformed in 2001, 2002, and 2008 – but also that active managers’ outperformance hasn’t shown any meaningful signs of improving, despite the inflows into passive strategies.
In the UK, over the last 10 years, 75% of large cap UK active managers underperformed, 73% of mid cap, and 80% of small cap. Once factor exposure is considered, 95% of UK active funds underperform their benchmarks.
The results for underperformance of active managers are consistent throughout Europe, Japan, Emerging Markets, real estate, and bond markets.
For those that are looking for further evidence, the ‘Active vs Passive’ section of this blog contains plenty of evidence from multiple independent sources studying the active vs passive debate, along with discussions of the findings.
Conclusion
It’s true that correlation doesn’t prove causation, and the fact that active managers still struggle to outperform the index doesn’t prove that index investing strategies aren’t distorting the market. There may be limits to the extent that active managers are able to capitalise at scale on any inefficiencies caused by index investing, such as restrictions on short-selling, which may prevent them from profiting on stocks’ overvaluations.
However, the fact that active managers’ performance has proved so woeful compared to their indices, and shows no sign of improving, does imply that if passive investing was in fact causing glaring inefficiencies, then sufficient profits would exist to motivate active managers to take advantage and outperform.
The lack of outperformance from active managers is strong evidence that passives aren’t distorting the market.