Bad day to be a mutual fund manager

These days, it’s considered standard investment advice to tell retirement-savers to throw money into a passive index fund and call it a day. But new research suggests passive investing isn’t just outperforming active managers—it could be stacking the deck against them.

Passive investing has become the new norm for good reason: For the average person saving for retirement or creating a financial cushion, picking stocks and trying to time the market is futile. Plus, time and time again, we see that most actively managed funds underperform the S&P 500.

Actively trading, actively struggling

Mutual fund managers, to be fair, don’t have an easy job. They not only have to pick undervalued stocks, but convince investors that paying management fees is worth it.

A new paper by Hannah Unterberg, a PhD candidate at the University of California Irvine, finds that active managers aren’t just imagining it: The rise of passive investing is, in fact, making their jobs harder.

Unterberg’s research shows that when investors pull money out of active funds and put it into passive indexes, that flow gives an automatic price boost to companies in the index. Meanwhile, stocks outside the index—that an active manager picked—get no such boost, and can even get penalized as money moves away from them.

“A flow-driven framework shows that capital reallocations toward passive funds generate asymmetric price pressure, penalizing funds’ active tilts,” explained Unterberg in the paper. And she ties this dynamic to part of the decline in active-fund performance since 2010.

The passive investing white wale

Some experts, the most vocal being hedge fund manager David Einhorn, have long argued that passive investing is distorting the entire market, and that large-cap stocks are getting bought up not because investors believe in the businesses, but because passive funds buy them automatically. This, according to Einhorn, distorts pricing and overvalues large companies, leading to a “broken” market. This is a hot take for a reason—many analysts disagree with this characterization—but Unterberg’s research gives the milder version of Einhorn’s argument some support.

The bottom line: When it comes to funds of all kinds, the competition to have the lowest fees is cutthroat. And in that category, passive funds really can’t be beat. —LB