Passive Investing Is Driving the Decline of Active Fund Alpha. Here’s What That Means for Investors

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.

Unfortunately, subsequent research has found problems with the conclusions drawn by Cremers and Petajisto. Using the same database they employed, Andrea Frazzini, Jacques Friedman and Lukasz Pomorski of AQR Capital Management examined the evidence and the theoretical arguments for active share as a predictor of performance and presented their findings and conclusions in the paper “Deactivating Active Share,” published in the March/April 2016 issue of the Financial Analysts Journal. The authors concluded that, controlling for benchmarks, active share has no predictive power for fund returns.

The October 2016 paper by Ananth Madhavan, Aleksander Sobczyk and Andrew Ang of BlackRock, “Estimating Time-Varying Factor Exposures,” provided an out-of-sample test (post-2009) of Cremers and Petajisto’s findings. They found that the measure of active share proposed by Cremers and Petajisto was negatively correlated (by 0.75) to fund returns after controlling for factor loadings and other fund characteristics. Thus, they concluded that “it is not the case that high-conviction managers outperform.”

In an October 2016 update of his original paper, “Active Share and the Three Pillars of Active Management: Skill, Conviction and Opportunity,” Cremers covered the period 1990-2015 and found that while the highest active share had an abnormal (unexplained) return of 0.71% per year, it was not statistically significant (t-stat was just 1.37). Given that he noted the outperformance had occurred before 2002, I contacted Cremers and asked him if he had performance data for 2002–15. He provided me with the table below, which shows the results over that time frame for the active share quintile portfolios (the first quintile is the lowest active share).

While active share may have worked before 2002, these results show that even the highest quintile of active-share funds produced negative alphas in the post-2002 period. In other words, as markets became more efficient over time, the alpha was “gone with the wind.”

Further evidence of the declining performance of active share is Morningstar’s 2021 paper “Unattractive Share,” which demonstrated that since 2011, investors in high-active-share funds in all Morningstar categories have paid higher fees, incurred greater risks, and earned lower returns. While it may have provided a ray of hope at one point, as Andrew Berkin and I demonstrated in our book, The Incredible Shrinking Alpha, the markets have become increasingly efficient over time, raising the hurdles for active management.

The evidence that demonstrates a declining ability of active managers to generate alpha after fees flies in the face of the theory that the increase in passive investing’s share would lead to less informational efficiency and less price discovery by active managers and would lead to more market mispricing and more opportunity for active managers to add value.

That contradiction 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.

6 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). This isn’t explained by rising fees—expense ratios actually fell over the same period. Gross of fees, the picture is just as telling: Consistent with the findings of Fama & French (2010), before fees the value-weighted active fund sector performed similarly to the market portfolio, with alpha close to zero, during the 1984–2009 period. After 2010, the value-weighted portfolio earns a four-factor gross alpha of negative 0.66% per year. And the decline in fund performance is concentrated among the funds with the highest active share. Over 2010–24, the four-factor alpha of high-active-share funds was negative 2.41% versus negative 0.90% for low-active-share funds, with the difference (negative 1.51%) being statistically significant at the 5% confidence level.

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. The swing between periods exceeds 1.9 percentage points and is statistically significant.

3) Flow-induced demand explains the reversal. Unterberg builds a fund-level measure of “flow-induced trading”: essentially, the mechanical portion of a fund’s trading driven purely by investor inflows/outflows applied proportionally to existing holdings, stripped of any discretionary, information-based trading decisions. She 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.
• A 1-percentage-point increase in a fund’s quarterly flow-induced demand is associated with a 1.8- to 2.7- percentage-point increase in contemporaneous returns: a substantial price multiplier.
• 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.

4) Passive flow effects are persistent; active flow effects are transitory. The price pressure from active fund flows mostly reverses within a few quarters (consistent with prior fire-sale literature). But the price impact from passive flows remains at roughly half its initial magnitude even three years out. Because passive investing represents a secular, continued reallocation of capital rather than a temporary liquidity event, its effects on relative pricing don’t get arbitraged away the way transitory flow shocks typically do.

5) Beginning-of-month evidence supports causality. Using a clever natural experiment—401(k) contributions create mechanical passive inflows at the start of each month—Unterberg shows that low-active-share funds earn higher returns in the first three trading days of the month (2.6 basis points higher when passive flows are elevated), while high-active-share funds earn lower returns (2.1 basis points lower) over the same window. Active fund flows show no comparable pattern. This timing-based test is about as close as you can get to plausibly exogenous identification in this literature, since paycheck-driven 401(k) contributions don’t respond to recent fund performance.

6) The industry-level “returns to scale” relationship also flipped. Historically, a larger passive share of the industry predicted a wider active-minus-passive return spread (less competition benefited active managers). After 2010, a larger passive share predicts a narrower spread. The mechanical demand effect from reallocation now outweighs any competitive benefit from a shrinking active sector.

Investor Takeaways

1. 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.

2) 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.

3) The funds most exposed are precisely the ones with the biggest benchmark deviations. Funds holding concentrated, high-conviction, off-index positions are structurally the most exposed to this flow-induced drag, since their idiosyncratic holdings are exactly what gets sold down (or simply isn’t bought up) as capital migrates to index products. Closet indexers are comparatively insulated—not because they’re more skilled, but because their portfolios look enough like the benchmark to avoid the worst of the mechanical pressure.

4) This headwind is a function of the size and direction of the passive shift, not a permanent feature of markets. If passive flows decelerate, reverse, or plateau as a share of the industry, the mechanical pressure on active tilts should, by this paper’s own logic, ease. The current environment may not be representative of the long-run relationship between active management and performance.

Implications for Market Efficiency

This paper sits squarely in a growing body of literature (for example, Xavier Gabaix and Ralph S.J. Koijen’s “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis”) that challenges the classical view that prices reflect fundamentals because markets are deep and elastic. If markets were fully elastic, fund flows would be absorbed without lasting price effects, and the source of an active fund’s underperformance would have to be something else: fees, poor security selection, and so on.

Unterberg’s findings suggest something closer to the opposite: 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.

3) It raises a forward-looking question about who will play the price-elastic role going forward. In the model, it’s “direct investors” (those managing their own portfolios, price-sensitive by construction) who absorb the supply/demand imbalances created by the active-to-passive shift. As that pool of capital shrinks relative to the market—a long-running trend in its own right—the price-impact multiplier should mechanically rise, meaning future flow shocks of the same size could move prices even more.

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.

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.