Time-varying Alpha Opportunities and the Growth in Passive Fund Management

Abstract

During the last decade, the U.S. mutual fund industry experienced an unprecedented movement toward passive investments. We tie this shift to underperformance in active funds stemming from a reduction in alpha opportunities. As alpha opportunities decrease, performance predictors like Active Share and R-squared lose their effectiveness, and performance fails to persist. Moreover, the relation between alpha and fund costs turns significantly negative, investor outflows become more sensitive to poor performance, and passive funds see higher inflows. These findings are consistent with outperformance of mega cap stocks reducing alpha opportunities and a subsequent increase in the market share of passive funds.

Keywords: mutual funds, passive investing, performance persistence, flow performance relationship

JEL Classification: G23