Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 676

How passive investing is driving the decline of active fund alpha

An overwhelming body of academic research demonstrates that the past performance of actively managed mutual funds does not provide valuable information as to future performance. For example, Eugene Fama and Kenneth French, authors of the 2010 study “Luck Versus Skill in the Cross-Section of Mutual Fund Returns,” found that fewer active managers (about 2%) were able to outperform their three-factor (beta, size, and value) model benchmark than would be expected by chance.

However, believers in active management were offered hope with the 2009 study by Martijn Cremers and Antti Petajisto, “How Active Is Your Fund Manager: A New Measure That Predicts Performance,” published in The Review of Financial Studies. The authors concluded: “Active share predicts fund performance: Funds with the highest active share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence.”

Active share is a measure of how much a fund’s holdings deviate from its benchmark index, and funds with the highest active share tend to have the best performance. Thus, while there’s no doubt that, in aggregate, active management underperforms and the majority of active funds underperform every year (and the percentage that underperform increases with the time horizon studied), if an investor were able to identify the few future winners by using active share as a measure, active management could be the winning strategy.

This raises an interesting question: Has the secular shift toward passive investing – index funds and exchange-traded funds have grown from about 19% to over 50% of equity fund assets since 2010 – changed how active funds perform, and if so, through what mechanism? Hannah Unterberg attempts to answer that question in her June 2026 paper “Passive Flows, Active Woes: Passive Investing and the Decline of Active Mutual Fund Alpha.”

What the paper examines

Unterberg studied US domestic-equity mutual funds and ETFs from 1984 to 2024, using CRSP fund data merged with Thomson Reuters holdings data. She found that active performance has deteriorated sharply as the relationship between active share and performance didn’t just weaken after 2010 – it flipped entirely. Her explanation is a flow-driven mechanism: When investors pull money from active funds and into index funds, the active managers are forced to sell down their existing (often concentrated, off-benchmark) positions, while passive inflows buy mechanically in benchmark weightings regardless of price. This creates lopsided demand – selling pressure on stocks that active managers like, buying pressure on stocks they don’t hold – and that pressure shows up directly in fund returns.

Key findings

1. Active fund alpha roughly doubled in its underperformance after 2010. Using the Carhart four-factor model, average net alpha for active funds fell from negative 0.72% annually (1984–2009) to negative 1.82% annually (2010-24). 

2. The active-share premium reversed. Before 2010, high-active-share funds beat low-active-share funds by 0.85% annually (gross, four-factor). After 2010, high-active-share funds underperformed low-active-share funds by 1.11% annually. 

3. Flow-induced demand explains the reversal. Unterberg finds:

  • Before 2010, active share positively predicted future flow-induced demand: Active funds benefited from flows.
  • After 2010, active share negatively predicts flow-induced demand: The more a fund deviates from its benchmark, the more adverse flow pressure it faces.
  • When flow-induced demand is added as a control in return regressions, the negative active-share coefficient becomes statistically insignificant. In other words, controlling for flow pressure largely explains away the post-2010 active-share underperformance. Manager skill has not deteriorated, market structure is the cause of the decline.

Investor takeaways

Active share is no longer a reliable positive signal. A measure that was a useful predictor of outperformance through the 2000s now correlates with underperformance in the current environment. Investors and advisors who are still using active share as a simple screen for skilled managers should be aware that the historical relationship has not just weakened, it has reversed.

This is a story about demand mechanics, not eroding manager skill. That distinction matters for how investors interpret active fund track records. Underperformance driven by structural flow pressure is a different phenomenon than underperformance driven by managers losing their edge – and it has different implications for whether skilled stock-picking still has value once the flow headwind subsides or reverses.

Implications for market efficiency

Unterberg’s findings suggest capital reallocation toward passive vehicles is large enough, and the supply of price-elastic capital willing to absorb it is limited enough, that flows themselves move relative prices in economically meaningful and persistent ways. That has a few implications worth sitting with.

1. Price discovery may be getting less efficient at the margin for stocks where active and passive ownership diverge most. If the buying/selling pressure described here doesn’t fully arbitrage away over a three-year horizon, prices for some securities are, at least temporarily, being set as much by mechanical flow as by anyone’s assessment of fundamental value.

2. It complicates simple “passive investing makes markets more efficient because it pushes out unskilled active managers” narratives. The paper directly tests and rejects the idea that a shrinking active sector should mechanically improve the performance – and by extension, the price discovery quality – of the managers who remain. The source of the contraction matters: Managers exiting on account of flow-driven redemptions face a different competitive landscape than managers exiting because of genuine underperformance.

Unterberg’s paper offers a useful reframing of the question: Why did the historical edge associated with high active share evaporate – and reverse – just as passive investing became the dominant force in equity markets? The answer she provides isn’t that “active managers got worse.” It’s that the market’s plumbing changed. Reallocation from active to passive funds creates structural, asymmetric demand that disproportionately penalizes exactly the kind of benchmark-deviating bets that used to define skilled active management.

Concluding thoughts

For evidence-based investors, this is a reminder that performance predictors aren’t static laws of nature – they’re conditional on market structure, and that structure has shifted meaningfully over the past 15 years. It’s also a useful caution against treating “passive investing makes markets more efficient” as an unconditional truth. The mechanism documented here suggests that, at least for the segment of the market most exposed to active-to-passive flow rotation, the opposite may currently be true.

 

Larry Swedroe is a freelance writer and author. The views expressed here are the author’s. For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. The author does not own shares in any of the securities mentioned in this article.

This article was first published by Morningstar.com, and has been edited for Firstlinks. 

 

  •   19 August 2026
  • 2
  •      
  •   

RELATED ARTICLES

An obsessive focus on costs may be costing investors

Mapping future US market returns

History suggests the Magnificent Seven are headed for a fall

banner

Most viewed in recent weeks

It’s time for LICs to die

A high-profile dividend cut and a prominent fund manager’s apology have reignited a long-running debate. If investors can access similar exposures more cheaply and efficiently elsewhere, what exactly is keeping LICs alive?

Testamentary trusts survived the trust tax. The drafting battle has just begun.

The fight over testamentary trusts looked settled. Then the draft legislation arrived. Hidden in a technical detail is a question that could force many families to rethink wills they thought were already future-proof.

Is it time to bail on Australian stocks?

For generations, Australian investors have backed banks, miners and dividends. But has that loyalty come at a cost? A look at the numbers raises an uncomfortable question about where future returns will come from.

The new capital gains tax trap for your portfolio

Investors have long accepted one portfolio rule without much question. A major tax shift could change that calculation entirely, forcing difficult trade-offs between risk, discipline and an overlooked cost lurking beneath.

How the typical Australian Family could save $844,350 in taxes

The value of a testamentary trust is not determined by wealth alone. Depending on circumstances, it can reduce the tax burden on inherited income, create efficiencies and help build intergenerational wealth.

The retirement scorecard: how many of these questions can you answer?

From the maths of retirement, estimating spending and picking the right asset allocation to survive a poor decade, here are the questions every retiree – current or future – should be able to answer for themselves.

Latest Updates

Retirement

The retirement scorecard: how many of these questions can you answer?

From the maths of retirement, estimating spending and picking the right asset allocation to survive a poor decade, here are the questions every retiree – current or future – should be able to answer for themselves.

2026 is not 1999

The US market looks eerily similar to the dot-com era with soaring AI spending and tech giants dominating returns. But one difference separates today’s boom from the dot-com bubble and it could determine what happens next.

Planning

Taxing time for trusts

Trusts are facing a shake-up, but an overhaul may not be necessary. Families can explore restructuring strategies that preserve succession and the asset protection benefits that have made these structures valuable.

Economy

Why the US economy is stronger than you might think

War, inflation and higher rates were expected to derail America. But has the market got it wrong? Three forces are driving the economy beyond expectations, revealing implications for stock prices and portfolio positioning.

Gold

How much trust is in your portfolio?

Everyone talks about diversifying assets. Far fewer think about diversifying trust. As inflation, debt and market assumptions collide, the question is whether portfolios need greater protection from unexpected outcomes.

Retirement

Retirement in reality - 7 months in

Seven months into retirement, I'm still uncovering surprises. This month was spent reflecting on the slow pace of health change, the myth of neatly scheduled part-time work and the unexpected persistence of retirement guilt.

The new geography of technology leadership

The next chapter of technology may not belong to the companies or business models many expect. As the landscape shifts, some opportunities are emerging in places that remain surprisingly overlooked by global markets.

Sponsors

Alliances

  • ASA-Logo-RGB-ActiveGreen-web.png

© 2026 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.