Abstract: This paper studies whether the secular shift toward passive investing has affected active fund performance through flow-induced demand effects. Using U.S. equity fund data (1984–2024), I document a decline in active fund performance after 2010, with average annual four-factor alpha falling by around one percentage point and the previously positive relation between Active Share and performance reversing. These patterns contradict theories predicting improved performance as the active sector shrinks. A flow-driven framework shows that capital reallocations toward passive funds generate asymmetric price pressure, penalizing active tilts in funds. Flow-induced demand significantly impacts fund returns, with the effects of passive flows persisting over multiple years. Controlling for flow-induced trading can explain the negative Active Share–performance relationship, suggesting that underperformance reflects structural demand headwinds rather than declining manager skill. Higher-frequency tests exploiting plausibly exogenous, beginning-of-month passive flows provide additional evidence.
Discussant: Erik Loualiche, University of Minnesota
Abstract: About 88% of mutual-fund assets are held by retail investors, who rarely take short positions because of the associated costs and risks. Yet mutual-fund performance is traditionally measured by alpha, which implicitly assumes investors can freely short the benchmark factors. We show that mutual-fund performance for constrained investors is measured by achievable alpha, computed using only factors with strictly positive weights in the shortsale-constrained benchmark portfolio. Empirically, achievable alpha and value-added reveal weaker absolute performance and starkly different rankings. Achievable alphas predict fund flows---especially during market turmoil---and indicate that funds are less scalable than implied by traditional alphas.
Discussant: Winston Dou, University of Pennsylvania
Irina Stefanescu, Federal Reserve Board of Governors
Alexey Vasilenko, Monash University
Abstract: This paper documents substantial asset ‘reclassification’ in the U.S. mutual fund industry:
fund assets are moved into twin separate accounts and collective trusts sharing the same
strategy and portfolio team. In 2021, transfers between mutual funds and their twin vehicles
exceeded $550 billion. These reclassifications involve no investor flows, yet they distort
measured fund flows, creating a non-classical measurement error that biases coefficient
estimates in flow-based regressions. Adjusting for reclassification changes the estimates of
central relationships in the mutual fund literature, such as flow-performance sensitivity and
smart- and dumb-money tests.
