Active and passive management have a symbiotic relationship. Active management keeps markets efficient, allowing passive management to exist. But the proliferation of passive management can and does lead to pricing anomalies that seem to justify the continued presence of investment selection.

The case for passive management has been strong; markets’ increased efficiency translates into fewer pricing anomalies and opportunities to outperform benchmarks. Additionally, passive investing has typically been less expensive. Indeed, index funds now account for investment in one-fifth of all US mutual funds and one-third of all US equity funds.

But both styles of investment management appear to support each other in a virtuous circle. Adherents of passive investing claim that greater market efficiency makes for fewer opportunities to identify and exploit mispricings, but it is active managers who identify those anomalies and increase market efficiency. In a further twist of irony, the profusion of passive management has led to decreased market efficiency. Index managers attempt to minimize tracking error by adjusting holdings in response to investor in- and outflows rather than by changing company fundamentals.

The authors gather evidence from several sources on the unintended consequences of passive investment management:

• Stocks that index funds own in large quantities tend to exhibit increased long-term pricing anomalies.
• As exchange-traded funds—usually passive investors—increase their ownership of a stock by one standard deviation, that stock, in turn, experiences a 16% increase in daily trading volatility.
• Index fund growth has been behind increased correlations of US equities, making risk reduction through diversification more challenging.
• Because the expansion of index funds has led to increased market risk and volatility overall, the costs of these funds tend to be higher than might be expected.

Active investment costs more to those who subscribe to this investment style but benefits all investors through the creation of greater overall market efficiency. Similarly, although index funds may cost their investors less, they tend to engender decreased efficiency that all investors experience.

The authors’ findings provide useful and practical counsel for investment strategists and portfolio managers.

The debate on the merits and demerits of active and passive management is less straightforward than commonly thought. Their codependent relationship needs to be one of balance and peaceful coexistence. All things are good in moderation.