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New Insights on the Critical Role of Active Management
March 11, 2025
The theory is clear: active management plays an important role in maintaining market efficiency. By performing research on securities, active managers ensure that market prices are closely linked to underlying value.
And four new studies help confirm that reality aligns with theory. These studies look at how the shift from active investing to passive investing has affected market dynamics.
In “How Competitive is the Stock Market?,” Valentin Haddad, Paul Huebner, and Erik Loualiche consider what happens when a subset of investors changes its behavior.
They note that when active investors are surrounded by less aggressive passive traders, active investors trade more aggressively. In theory, the increased aggressiveness by active investors should completely offset the decreased aggressiveness from passive investors. However, the authors find that active traders’ reaction offsets only two-thirds of the effect of the shift to passive investing.
Given that the shift from active to passive has been substantial, changes in market dynamics must be substantial as well. The study concludes that, over the past 20 years, the demand curves for individual stocks have become more inelastic by 11%. In other words, a change in the price of stock has 11% less of an effect on demand for that stock then it did 20 years ago. That means that the market will be slower to correct mispricings than it was previously.
In a similar vein, “Limits to Diversification: Passive Investing and Market Risk,” by Lily Fang, Hao Jiang, Zheng Sun, Ximing Yin, and Lu Zheng, finds that as the market share of passive investing has risen, so has market volatility, driven by higher correlations among individual stocks. Ownership by passive funds appears to drive this phenomenon: more ownership by index funds and ETFs means higher betas, correlations, and covariances.
The effect of passive investing becomes even more pronounced in periods of crisis. In the post 9/11 period, the 2008 financial crisis, and the 2020 Covid pandemic, the “risk contribution of stocks with high exposure to passive investing” increased.
The authors note that these changes in market dynamics have a profound real-world effect. When correlations increase, the benefits of diversification decrease, making it harder for investors to reduce risk by diversifying.
Taking a different approach, Ponya Behmaram, in “From Realized to Expected: The Passive Investing Impact,” considers how the rise of passive investing has affected stock prices, finding that “the rising trend in passive investing could be artificially boosting the prices of highly indexed stocks.” While positive for passive investors in the short-term, the artificially high prices could mean reduced returns in future, posing a risk to the long-term health of retirement funds.
Behmaram’s analysis also provides insights into the recent underperformance of value stocks and small-cap stocks. The author concludes that half of value’s underperformance and almost all of small-cap’s underperformance results from their relatively low level of ownership by index funds.
Exploring the same theme, “Passive Investing and the Rise of Mega-Firms,” by Hao Jiang, Dimitri Vayanos, and Lu Zheng,” finds that “flows into passive funds raise disproportionately the stock prices of the economy’s largest firms,” particularly overvalued large firms. This effect is so strong that flows from active funds into passive funds can push up the market, even when net flows into the market are zero.
These four studies add to the already substantial body of literature documenting the impact of the rise in passive investing and the critical role of active management. “Powering Past ‘Peak Passive’? Insights on the Active-Passive Balance from the Literature on Market Efficiency” by Theresa Hamacher provides a complete review of this literature. The Active Managers Council provided research support for this paper.
Acknowledgement: Thank you to Jonathan Klement, author of the Klement on Investing blog, for bringing some of these papers to attention. Read his excellent summary of “Powering Past ‘Peak Passive’?”