Throughout the choppy stock markets of the last three years, passive index funds and strategies have continued to gain market share from actively managed products. Investors seem to prefer simple, low-cost investing and resist a siren’s call of potentially better returns from active management during declines.

But the ongoing shift to passive investment products raises a longstanding question: What happens to price discovery?

Craig Lazzara, managing director for core product management at S&P Dow Jones Indices, asks this question: Without active managers figuring out prices, how would we know that an inefficient market is happening? One indicator would be if it were increasingly easy for active managers to generate performance “and you don’t see that inefficiency creeping in. I don’t see any signs at all that it’s happening: The concept makes sense theoretically, but I don’t think we’re there.”

Passive Needs Active
Passive investors take prices as they are. If $1 million is to be invested in a broad stock market index, that investment will occur whether or not a stock like Apple is being traded at a fair price. Usually these passive investments occur in capitalization-weighted, comprehensive funds—things that don’t use factors, fundamentals or smart beta.

Prices come from the interplay of active buyers and sellers in the market motivated by a view of the correct valuation for a security, says Lazzara. It is the price-seekers who create a more-or-less efficient market in large-cap equities, where prices at least trend toward some consensus on fair value.

“That means that passive investors rely on, to some degree, the existence of active investors in order to set prices,” he says. “Therefore, if you ask what is ultimately the fraction of assets that can be managed passively, the answer is not 100%. Whether it is 95% or 90% or 98%, I don’t know, but it’s not 100%.”

If 100% of assets were passively managed, there would be no actors in the markets seeking mis-valuations to correct, says Lazzara, and prices would have a random relationship with actual value. At some point, if we approached 100% passive management in the stock market, prices would become disjointed, and that would create more opportunities for active managers, he says, but where that point is—how far away markets are from that point now, how investors would know when that point is reached, and whether it can actually be reached—is still a matter for debate.

There are no sure estimates of what proportion of assets are truly passive right now, says Lazzara, but he estimates that it’s somewhere between one-quarter to one-third of all investments. “Certainly, I said in my recent blog that you could go up to 80% of assets being passively managed and still, under reasonable assumptions, see over half of all trading being done by active managers,” he says. “So the time that something like this happens is well away.”

In fact, Lazzara believes that more than 90% of all assets could be passively managed and still have a substantial enough amount of trading from active managers to enable price discovery to take place. There’s also no evidence of an acceleration toward a peak passive event.

Shrinking Opportunity
But the ongoing move to more passive indexed investing is draining the pool of alpha that active managers can offer. “If no one or almost no one is looking for mis-valuation in the market, then there’s likely to be more mis-valuation, and it should become easier to generate outperformance as an active manager,” says Lazzara. “The trouble is that, regardless of whether active managers are 70% of the market or 50% or 30% or 10%, the only source for outperformance for winners is the underperformance of the losers.”

Think of active management performance in terms of assets, not investors or managers—median performance would be the point at which 50% of actively managed assets outperform and 50% of actively managed assets underperform. If we consider the nature of securities trading, this makes sense—for every winning trade we make, there has to be a market participant on the other side of us, making what we would consider a losing trade. Thus the positive and negative alpha created by active investment decisions balances out, with this median performance as a fulcrum—and the point at which price discovery takes place.

Passive index fund investors are literally sitting out the activity in the marketplace, so the only source of positive alpha for winning active managers is the negative alpha of the losing active managers. If half of the actively managed assets in the marketplace underperform the market average by 2%, it means that the half of assets that outperform will do so by no more than 2%, all told.

So if 90% of actively managed assets underperform by 2%, the 10% of assets that outperform have to outperform by an average of 18%, says Lazzara. In a situation where a large number of asset managers underperform by a small amount, enabling a small number to outperform by a large amount, an equilibrium might be reached to slow or stem the flow of assets from active to passive management. Investors would chase the higher returns of winning active managers, while also feeling reluctant to fire a manager who only underperformed by 1% to 2%.

“If you look at our SPIVA data, on average two-thirds of large-cap active managers underperform the S&P 500,” Lazzara says. “In some years 80% of managers underperform, but it averages out to be about 60% in any given year. This kind of conjecturable equilibrium would require a much higher proportion of managers to underperform.”

Does Active Have Its Place?
“In reality, there aren’t any good environments for active managers,” says Lazzara. “Some are less bad than others. Some things do in fact help active management, but not as much as you may think.”

Lazzara has also used 20 years of SPIVA market data to research periods in which it is thought that active managers can shine. For example, when markets go down a lot, it’s thought that active managers might have an advantage because they are able to hold cash while indexes have to be fully invested.

To a degree, that’s true, says Lazzara, as between 2001 and 2020 active managers’ performance against a passive benchmark did improve in “bad market” years (where benchmarks were down 10% or more) versus “good market” years (where benchmarks increased more than 10%). In the 12 “good” years, 66% of active managers underperformed, while in the four “bad” years, 63% of active managers underperformed. “So yes, it helps when the market goes down, but it doesn’t help a lot,” he says.

Active managers should, theoretically, shine when smaller capitalization stocks do better than large- and mega-capitalization stocks, says Lazzara, as few managers are making their names by overweighting the largest companies in the market.

So Lazzara set up a study of active managers over the same 20-year period from 2001 to 2020, identifying good years for the largest companies by finding out when the performance of the S&P 100, the 100 largest stocks in the S&P 500, exceeded that of the S&P 500. Over the past 20 years, in the six years in which the S&P 100 did better than the S&P 500, 67% of active managers underperformed. In years where the S&P 100 did worse, 60% underperformed. So active managers were only slightly helped by the market’s tendency to periodically favor its largest stocks.

“The reality is that it’s extremely difficult to outperform,” Lazzara says. “It all comes back to the problem that the only source for outperformance for outperformers is the underperformance of underperformers. There’s a natural balance there; alpha generation is a zero-sum game, and that definitely comes through in the data—and not just our data.”

Draining The Pool
As more passive indexing takes place, there’s a smaller pool of alpha available—a smaller number of active managers, a smaller amount of active assets, and a smaller pool of underperformers—all of which leads to smaller winnings for the outperformers.

Suppose there is $100 billion in an investment market, with all of it active. Half of the assets underperform collectively by 2%. The successful assets, a pool of $50 billion, gain 2%, $1 billion of alpha to divide among themselves.

Now imagine 10% of this $100 billion market becomes indexed. Now $90 billion is actively managed, with $45 billion of that total outperforming, and $45 billion underperforming. What’s more, because the index culled the worst-performing of the active managers, the underperformance of the losers must also shrink—for the purposes of this example, to 1%. That means the margin of underperformance is now 1% of $45 billion, or $450 million of alpha to divide among the winning active managers.

“In our scenario, an indexed solution and the failure of the worst active managers shrank the pool of positive alpha by more than 50% because there was less active money available to underperform, and the average ability of active managers got better,” says Lazzara. “The likelihood of severe underperformance is less, but there’s less to be gained from being active.”

The Disappearance Of The .400 Hitter
So while indexes try not to play a role in active price discovery, they have had a compounding effect of culling the worst of the active managers—or, as Lazzara puts it, “the lion catches the slowest zebra of the herd.” The long-term effect is that the active managers of today are, on average, smarter, more well-informed and more skilled than those of yesteryear, he says, but they have a much harder time producing results for investors because the pool of available alpha is relatively smaller and significantly more difficult to access.

Think of poker playing. A room full of novices with poorly honed card-playing skills are easy prey for intermediate players, while that same intermediate player might be in over their head in a room of high-rolling seasoned professionals.

“Your success does not depend on your level of skill absolutely, it’s your relative level of skill,” says Lazzara. “As relative skill becomes higher and higher, one’s ability to stand out is less and less.”

He points to “Alpha and the .400 Hitter,” a piece of investment commentary from the CFA Institute’s Krisna Patel in 2016, which notes that since Ted Williams last achieved the feat in 1941, Major League Baseball hitters have been chasing the .400 season batting average for more than 75 years (now more than 80 years) to no avail. Before that time, there had been several .400 seasons to note, most of which occurred before 1925.

During the 75 years between Williams’s feat and Patel’s article, the Major League hitter has become a physical specimen, and teams’ ability to analyze pitchers and defenses has become a lot more sophisticated, while the design of ballparks has become more accommodating to hitters and more difficult for defenders—but still no batter has achieved the .400 batting average.

Even as batters have improved, pitching and defense have improved at pace—if not more significantly. Over time, the variation in batting averages between players has shrunk. So while Major League hitters might be better athletes with better strategy than those of the first half of the 20th century, their opportunity set for hits is smaller because of the advances in pitching and defense. As a result, there are fewer outstanding hitting performances as the years go on and the chase for .400 becomes ever more elusive.

Today’s active managers face the same squeeze, says Lazzara, until “peak passive” comes—if it ever does.