The last few decades have seen a dramatic shift of assets away from active to passive (such as, but not limited to, index funds) strategies. The shift occurred due to the overwhelming body of evidence demonstrating that while it is possible to win the game of active management, the odds of doing so are so poor that it isn’t prudent to try. That is why Charles Ellis famously called active management the “loser’s game” — the surest way to win a loser’s game (like roulette or the slot machines) is to not play.
In 1998, when Charles Ellis wrote his famous book, Winning the Loser’s Game, about 20% of actively managed mutual funds were generating statistically significant alphas – they were able to outperform appropriate risk-adjusted benchmarks (at least on a pretax basis). The 2020 edition of my book The Incredible Shrinking Alpha, co-authored with Andrew Berkin, presents the evidence demonstrating that the percentage of active managers able to generate statistically significant alphas had collapsed — falling to about 2% even before considering the impact of taxes for taxable investors – notwithstanding their claim that the trend toward growing market share for passive investment strategies would increase their ability to do so.
The increased competition for investor assets, along with the introduction of lower cost exchange-traded funds, has led to a significant decline in the expense ratios of index strategies and similar passive strategies. For example, the Fidelity Total Market Index Fund (FSKAX) has an expense ratio of 0.015% (only 1.5 basis points). Based on the availability of a wide variety of low-fee passive funds, the fact that active funds underperform the market on a risk-adjusted basis on average, and the lack of evidence of any persistence of performance of active funds beyond the randomly expected, it could be said that passive investors are the “smart money” and active investors the “dumb money” playing a loser’s game.
New evidence
Jeffrey Busse, Kiseo Chung and Badrinath Kottimukkalur, authors of the January 2024 study Is Money in Index Funds Smart? provided further evidence that passive investors are the smart money. Their study was built on the work of Andrea Frazzini and Owen Lamont, authors of the 2009 study Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns, who found that while fund flows into active funds predict future performance, the outperformance is fleeting, lasting no more than a few months. The outperformance can also be explained by stock momentum and investor flow-related buying, which pushes up stock prices beyond the effect of stock return momentum – fund performance is due to flow-related trades, not managers’ skill. Their findings led Frazzini and Lamont to conclude: “Retail investors direct their money to funds which invest in stocks that have low future returns.” In other words, active investors are dumb money.
Busse, Chung and Kottimukkalur’s data sample was from the Center for Research in Security Prices (CRSP) mutual fund database and covered domestic funds over the period 1996-2022. Each year they sorted funds into groups based on the flows (inflows or outflows) they received during the previous year. They included only pure index funds in the passive category, excluding index-based funds and index-enhanced funds. Assets under management for index funds in their sample exceeded $4.5 trillion in 2022.
Busse, Chung and Kottimukkalur computed the abnormal performance of funds based on both the Capital Asset Pricing Model (CAPM) alpha and the Carhart four-factor (beta, size, value and momentum) alpha. Consistent with the efficient market hypothesis, they found that while the average CAPM and four-factor alphas for index funds was around -6 basis points (bps) per month (roughly consistent with their mean 0.5% annual expense ratio), active funds showed abnormal performance of -9 bps per month for the CAPM alpha and -13 bps per month for the four-factor alpha (roughly consistent with the annual expense ratio of 1.15%). The authors concluded: “The negative alpha for active funds suggests that actively managed funds are unable on average to recoup the costs associated with active management via outperformance relative to the benchmark and provides some rationale for why we might expect passive fund flows to reflect the behavior of investors with greater sophistication.” However, that wasn’t the only evidence of greater sophistication they found among passive investors.
They also found no evidence of inflows outperforming outflows across a one-year investment horizon in active funds. And they found that active investor flows were naively driven by CAPM alphas. In contrast, passive investors’ flows were driven by the Carhart four-factor alphas, which took into account the fund’s exposure to the beta, size, value and momentum factors. This finding suggests that passive investors are not only more sophisticated in their choice of funds, but the funds they select are likely to provide higher risk-adjusted returns than their active competitors.
Investor takeaway
While active investors like to think of themselves as sophisticated investors, the evidence we reviewed demonstrates that they are naive performance chasers. In contrast, in aggregate it is the passive investors who are the “smart money,” refusing to play the loser’s game that is active management.
ABOUT THE AUTHOR
Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.
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