Abstract: This paper shows that the secular shift toward passive investing has contributed to reshaping active mutual fund performance through flow-induced demand effects. Using U.S. equity fund data from 1984 to 2024, I document a decline in the performance of active funds since 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 are difficult to reconcile with theories predicting improved performance as the active sector shrinks. I develop a demand-based framework showing that reallocations from active to passive funds generate asymmetric price pressure penalizing active tilts in funds. Flow-induced demand significantly impacts fund returns, with effects enduring over multiple years. Controlling for flow-induced trading attenuates the negative Active Share-performance relationship, suggesting that underperformance reflects structural demand headwinds rather than declining manager skill. Tests exploiting beginning-of-month passive flows provide additional causal evidence.
Discussant: Erik Loualiche, University of Minnesota
Abstract: Mutual-fund performance is traditionally measured by alpha, reflecting the utility gain of an unconstrained investor who has access to the fund in addition to the benchmark factors. Yet 88% of fund assets are held by retail investors, who are effectively shortsale constrained. We show that their relevant performance measure is achievable alpha, computed using only factors with strictly positive weights in the 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 alpha.
Discussant: Winston Dou, University of Pennsylvania
Abstract: This paper documents substantial asset ‘reclassification’ in the mutual fund industry,exceeding $450 billion in 2021. These reclassification events do not involve investor flows;instead, mutual fund assets are simply converted into twin investment vehicles, such as separateaccounts or collective investment trusts. Analyzing the implications of asset reclassification forthe mutual fund literature, we find that these events distort inferred mutual fund flows withoutreflecting actual asset movements at the investment product level. Failing to account for assetreclassification in flow-based regression analyses can lead to biased estimates, as it resemblesa non-classical measurement error. We first analyze scenarios in which mutual fund flowsserve as a dependent variable, focusing on flow-performance sensitivity. A regression utilizingreclassification-adjusted quarterly flows demonstrates a 40-100% greater flow-performancesensitivity for mutual funds with twin vehicles than one employing unadjusted flows. Wethen examine cases when flows serve as an independent variable, as in ‘smart money’ tests,where measurement error artificially inflates true estimates.
