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 average.

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.

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 stable.

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.