By: Alan D. Crane Ph.D. & Kevin Crotty, Ph.D.
For decades, the idea of investing in a fund or with a money manager and investing in “active management” were synonymous. If you were paying someone to do something with your money, you expected them to pick stocks or time the market (or maybe even both), and you hoped to earn abnormal returns (“alpha”).
This began to change in earnest in the mid-1990’s with the expansion and mainstream acceptance of index investing. The argument for such products was relatively straightforward. Take the manager out of the equation in the traditional sense. Rather than paying high fees for stock picking and/or market timing, pay low fees and get broad exposure to an asset class.
Why would we want to take the manager out of the equation? There were (and still are) some good arguments for this. First, it is not entirely clear that managers are uniformly talented at doing the things we thought we were paying them for. In fact, it was well accepted that some managers were quite bad at it. When looking at data just through 2000, 75% of actively-managed equity funds had negative estimated alphas over the life of their funds; that is, they failed to beat the market on a risk-adjusted basis. Second, it is really hard to pick the right manager, even if you think some are skilled.[1] Finally, if a manager is good and everyone knows it, they can charge high fees. Their fees could even be high enough that the manager, not the investor, keeps all the spoils of their skill. In other words, after fees, you shouldn’t expect to earn much, even if you’ve picked the right fund. Enter the index fund.
In theory, passive investing solves many of these issues. But, in practice, is index investing a good idea? The market sure seems to think so. The growth in passive investing over the last 30 years has been tremendous. In fact, if you look at the assets under management, passive funds make up just over 40% of assets under management compared to 3% in 1995. More importantly, 74% of net inflow went to passive funds from 1995 to the beginning of 2020.[2] And study after study has shown that, after fees, the average index fund performance is similar to that of active funds.
Critics of passive investing suggest that passive investors leave money on the table. In particular, active investors’ marketing campaigns implicitly focus on the idea that not all active funds are the same. Since there is variation in performance across funds, you need only invest in the right half of that performance distribution and you’ll outperform those index funds. In other words, you’ll never earn “alpha” if you invest passively. Don’t we all want to beat the market?
It’s easy to see merit in this argument (particularly if you ignore the fact that it’s hard to forecast which funds will be good in the future and the fact that managers may soak up their value-add in fees). But these arguments usually boil down to arguing against passive investment because investors shouldn’t accept average performance. In a 2018 article, we looked as this idea more closely and found some surprising results.[3] Our expectation was that all index funds would earn zero “alpha”—they would neither outperform nor underperform the market on a risk-adjusted basis. When you compare the variation in risk-adjusted performance in passive funds to that in active funds, you see a lot of variation in both sets. In fact, there’s substantial variation in the performance of index funds; so much variation, that the distribution of index fund returns looks an awful lot like the distribution of active funds.
The performance is most similar for good performance (the right side of the distribution), which is bad news for active managers – sometimes, index funds also outperform! On the left-side--the poor performing side of the distribution—index funds generally perform better than active funds; the long left tail for active funds (in red) indicates some do quite poorly while passive funds (in black) do not show up in this region at all. So index funds are sometimes above average, but when they underperform, it’s not nearly by as much as active funds.
“Wait, how can there be index funds that earn alpha if they’re completely passive?” The answer is, the funds don’t really earn the alpha, the index does. Index funds are not all created equal. Some track large, diversified indexes such as the Russell 3000 or the CRSP Total Market. Others track large cap indexes, or value stock indexes, or large cap value stocks. Index construction has become a cottage industry that slices and dices the investible universe into unique (and often small) slices. Now, by definition, some of these underlying indexes are going to outperform (or underperform) the market based on luck or because the index is taking a lot of risk. Funds that closely track such an index will earn non-zero “alpha.”
Of course, the same thing can happen for active funds as well. Much of the variation in performance across active managers can be attributed to the performance of their benchmark. So, is that really skill? And more importantly for investors, is it really skill that should command high fees?
This finding also has implications for thinking about index fund investing. As more and more investors heed the advice of academics, tremendous amounts of money are flowing into passive management. But the index fund space is becoming less passive as more “active” indices arise. Index funds that track boutique indices focusing on a small set of stocks with certain characteristics are in fact taking bets on an active strategy. As a result, investors in these index funds may find themselves under-diversified and perhaps paying higher fees.
“So, what does this mean for choosing active vs. passive funds?” Our research shows that choosing passive management does not necessarily mean that you’ll get an exactly average return—there is variation due to differences across indices in risk-adjusted performance. The lucky draws of risk-adjusted performance are fairly close for active and passive performance, but the unlucky (or unskilled!) poor risk-adjusted performance is much worse for active than passive management. Technically speaking, this means that no rational, risk-averse investor should choose a random active fund over a random passive one. In other words, the argument that going the passive route is settling for average ignores the real possibility that you will end up far below average by using active management, particularly after higher fees are taking into account.
[1] For a discussion of this issue, see our earlier blog post on luck vs. skill at INSERT LINK HERE.
[2] Aggregate AUM and flow data reported in Anadu, Krutti, McCabe, and Osambela (2020), Federal Reserve Bank of Boston Supervisory Research and Analysis Unit working paper.
[3] Crane and Crotty (2018). “Passive versus Active Performance: Do Index Funds Have Skill?” Journal of Financial and Quantitative Analysis, 53: 33-64.
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