A key pillar in the active versus passive management debate is the positive impact that
index-tracking alternatives can have on the performance and behavior of active fund
managers. The authors demonstrate improved competition in markets where explicit indexing
is more common. They also relate explicit and closet indexing to the regulatory
environment. Competitive improvements found include not only lower fees but also better
product differentiation through greater active share and even higher average alpha.
How Is This Research Useful to Practitioners?
For asset allocators, the decision whether to invest actively or passively can be complex.
The authors’ conclusions in this paper are contrary to the received wisdom that
active management is better in less liquid markets, where passive investment is less common.
The authors present evidence suggesting that active managers may be delivering better
products in exactly those markets where they encounter the fiercest competition from passive
alternatives. That is, the greater the market share in a country held in explicitly indexed
funds, the higher the average active share of active managers and the higher their alpha, on
For fund managers, evidence of the difference between countries regarding the extent of
indexation can be extrapolated to likely impacts on competition in the investment management
industry if the use of explicit indexing continues to grow. If explicit indexing becomes
more popular, the authors suggest that active managers should be ready for fiercer
competition, not only from passive alternatives but also from a simultaneous strengthening
in the offerings of their active peers. Moreover, evidence shows that closet indexing is
damaging to both flows and performance—another admonition to that portion of the
industry still delivering index-like returns at active fee levels.
How Did the Authors Conduct This Research?
The authors examine both actively and passively managed equity open-end mutual funds and
exchange-traded funds over 2002–2010. They obtain performance data and fund
characteristics from Lipper and link that information to LionShares data on fund holdings.
This dataset covers 24,492 funds in 32 countries—approximately 20% of the global
equity market-by-market capitalization. Throughout the paper, the authors control for
country and fund characteristics. Their results are largely consistent whether country of
domicile or country of sale is used.
Using panel regressions, the authors attempt to link a number of variables. First, they
explain the proportion of assets invested in a given style (active, closet indexed, explicit
indexed) in each country by using several variables, including fund industry size, industry
concentration, and GDP per capita. They then explain flows to and performance of active
funds by pointing to a combination of the funds’ features, notably showing a
significant positive relationship to active share and a negative relationship to total
shareholder cost in both cases. They also analyze the determinants of total shareholder
cost. Finally, the authors present an event study of the impact of the passage of pension
acts on the amount of explicit indexing, the active share of funds, and the cost of funds in
a country. They claim that this study amounts to a natural experiment, because it provides
an exogenous shock to a country in terms of index use while all other variables remain
The majority of the authors’ conclusions support a central hypothesis that is
anecdotally well established: Index tracking is putting pressure on active managers. The
rich data summarized by the authors give a more detailed picture of the impact that passive
investing is having and the sorts of changes that might happen if passive management further
extends its reach. One potential consequence outlined by the authors is the promise of
higher returns to active managers. But whether these higher returns would be a result of
competitive pressure driving up returns (by driving down fees) or a result of more
opportunities for alpha arising from a larger pool of passive money is an open question.