In this section and the following, we will explore how the growth in passive management will make the equity markets more efficient and decrease the variance of security pricing. However, we need to elaborate on a few key insights.

First, what does it mean for markets to be efficient? Per Investopedia, “Market efficiency is the degree to which stock prices reflect all available, relevant information.” So, the prevailing thinking is that active managers help markets achieve efficiency by pricing securities by estimating valuations based on available information. Of course, some active investors are better than others at estimating valuations. However, the difference in valuation estimates provides liquidity to the markets. No one will be motivated to transact if every investor thinks the prevailing price is right.

Second, on aggregate, active participants could not outperform the market because the aggregate active participants’ allocation amongst securities is the market allocation. Put another way, a security’s average weight (market cap weight) is established by the active participants’ preferences for one security over another. Hence, for every outperforming active manager, there has to be an equal underperforming active manager. On the other hand, passive investors only take the active participant’s average allocations (respective market capitalization weights) for each security. Therefore, it doesn’t matter if 90% of the asset are passively managed. For more, read: https://segresearch.com/2023/02/13/why-by-definition-active-investors-cannot-outperform-passive-investors/

Third, let’s establish the following:

• Investing in the equity market is a positive sum game thanks to the time value of money and risk. Investors get compensated for loaning their cash.
• Actively allocating amongst securities is a zero-sum game, just like poker. For every outperformer, there has to be an underperformer.

Finally, it is vital to realize that three types of managers will outperform at the expense of others:

1. Skilled managers: through better estimates and pricing or other tactics, skilled managers allocate to the securities that subsequently appreciate. 
2. Insider managers: investors and managers who possess inside information will outperform. Of course, trading based on inside information is illegal, but that has not prevented many from engaging in it.
3. Lucky managers: Through pure randomness, the lucky managers have allocated to the securities that have subsequently appreciated. Unfortunately, for the lucky participants, their long-term performance will eventually put them in the underperforming bucket.

Given the above, what will happen to the underperforming active managers? Steven Thorley, Ph.D., CFA, at Marriott School, BYU provides an excellent simple analogy worth summarizing.

Imagine you and others were offered the opportunity to participate in a multi-round basketball free throw shooting competition. For each round, you will have two options:

1. Shoot ten free throws and get a dollar for each made. (Taking the active approach)
2. Sit it out and take the average score of the remaining competing participants. (Taking the passive approach)

Notice that in each case, you are likely to make money (with the active approach, you need to make at least one free throw).

What will you do? You will wonder if you are better than the average free-throw shooter. If you are better, you will compete. On the other hand, if you are not very good at free throw shooting, you will sit it out and collect the average score.

Let’s assume you are better at free-throw shooting than those who did not drop out initially. The first round plays out, and unless you are unlucky, you will score more than many participants. However, many poor performers might sit out and take the average next round. What happens to the average score after the first set of below-average participants drops out? The average score will move up because now the competition is better. What will happen after the second round? And so on.

Thanks to the law of competitive markets, weaker players will be forced to drop out. In this case, the participants who underperform the average. The skills of the remaining competitors will continue to rise each cycle, and as the less skilled dropout, more skilled players will remain. Notice that the law of competition holds up in most skilled games. Do you think we will see another person in baseball batting above .400 mark? Do you think another player will score 100 points in one basketball game, like Wilt Chamberlain? Neither is likely since the competition in both those sports has risen. 

With this analogy in mind, we can answer our pressing question on the impact of passive investing. Underperformers will likely be displaced as passive management grows, leaving the most skilled managers to compete. Since the average skill has improved, so will pricing/valuations, leading to even fewer managers outperforming. For example, Warren Buffett has not generated anything close to his outperformance in the 1960s and 1970s. He has barely kept up with the index. Could that be because he is now competing with astrophysics and all kinds of other geniuses? I believe that is part of the reason.

To summarize, the increase in passively managed assets will increase the competition by taking out the less skilled managers. The higher skill of the competition will lead to more accurate pricing, although less alpha availability due to the higher average skill.