New Evidence Threatens Active Management

The academic evidence against active management is mounting. New research shows that information is incorporated into security pricing far too quickly for investors to profit from it.

In our book, The Incredible Shrinking Alpha, Andrew Berkin and I presented the evidence demonstrating that not only is active management a loser’s game (while possible to win, the odds of doing so are so poor it is not prudent to try), but it is a game that is increasingly difficult to win. We also described the major themes behind this trend toward the ever-increasing difficulty in generating alpha:

  • Academic research is converting what once was alpha into beta (exposure to factors in which you can systematically invest, such as value, size, momentum and profitability/quality). And investors can access those new betas through low-cost vehicles such as index mutual funds and ETFs.
  • In the zero-sum game that is active investing (it is negative sum after expenses), you need victims who can be exploited to be successful. Unfortunately, that pool of victims is persistently shrinking. Retail investors’ share of the market has fallen from about 90% in 1945 to about 20% today.
  • The amount of money chasing alpha has dramatically increased. Twenty years ago, hedge funds managed about $300 billion; today it is about $4 trillion. And while there were only about 100 actively managed mutual funds in the U.S. 60 years ago, that figure is now about 8,000.
  • For patient traders who don’t need to demand liquidity, bid-offer spreads and commissions have fallen, making it easier to arbitrage away anomalies.
  • The absolute level of skill among fund managers has increased – the competition is getting tougher and tougher.

Another hurdle for active managers is the increasing market share of indexing (and passive, or systematic, investing in general Markets have become less liquid, resulting in an increase in the market impact costs for active managers who demand liquidity when they trade. For example, the authors of the 2021 study, “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis,” estimated that investing $1 in the stock market today increases the market’s aggregate value by about $5.