Impediments to Active Stock Selection and the Growth in Passive Fund Management

Abstract

During the last decade, assets of passive funds have swelled while active funds have lost market share. This growth in passive investments coincides with a substantially more challenging environment for active stock selection, as reflected in a lower fraction of stocks with positive alpha, lower idiosyncratic volatility, and higher aggregate liquidity. As the opportunities to discover alpha decrease, the relation between alpha and fund costs turns significantly negative. To compensate, active managers reduce expenses and fund turnover. Nonetheless, the inverse relation between fund costs and performance leads to greater predictability in fund performance, a stronger inverse relation between fund costs and investor flows, and greater sensitivity of investor flows to past performance.