Why Passive Inflows May be Pulling Down Active Fund Performance

It’s always good to go with the flows … inflows, that is.

Passive investing may be pulling down the active market, a new research paper found, which argues a decline in active fund performance since 2010 has been driven by allocations to passive funds. As investors pour into index products, specifically passive index ETFs, active managers have to sell down their existing positions, and passive inflows go into benchmark weightings regardless of price, according to the study. It can also be a self-reinforcing cycle for active funds, which tend to have higher fees, said Brendan McCann, a senior associate manager research analyst for Morningstar.

“If an active fund performs poorly, and investors run for the hills to get out of the active fund, now that active fund has fewer assets, so you can lose economies of scale,” McCann said. “That makes it harder to compete on cost, which can be almost like a self-fulfilling prophecy.” 

Performance Anxiety

The reason passive inflows affect active performance is that stocks held by active funds experience selling pressure while underweighted stocks benefit, according to the paper. Policy may also have something to do with it, said Michael Green, founder of Tier1 Alpha Asset Management. Two decades ago, the Pension Protection Act of 2006 created qualified default investment alternatives, or QDIAs, which became the default investment portfolio in employer-sponsored retirement plans, like 401(k)s. The legislation changed the system from an opt-in framework, where investors had to decide whether to participate and what to buy, to an opt-out framework in which investments are pre-selected. “Because most people don’t want to spend a lot of time thinking about investing, particularly early in their careers, [most] QDIA portfolios never change their allocations,” Green said. “That’s just a natural, behavioral outcome.”

Other key findings from the report include:

• Active fund underperformance has roughly doubled after 2010, with average net alpha for active funds falling from -0.72% annually between 1984 and 2009 to -1.82% annually between 2010 and 2024.
• The sharpest alpha declines were among “high active share funds,” or portfolios whose stock holdings significantly differ from their benchmark index.

Following the Money: One out of every two dollars invested in ETFs went into low-cost, passive funds in the first half of this year. That trend could lead to a homogenized investing environment as active managers realize they won’t make money launching new active strategies anymore, Green said.

“Practitioners who pursue that [active] approach are going to see their returns further degenerated, which in turn causes more people to abandon the principles of actually actively valuing securities,” he added. “We are hollowing out the industry, even as assets under management approach all-time highs.”