By: Andrew Rymer, Jon Exley, and Duncan Lamont
The most popular argument used against active management, the so-called zero-sum game argument, is also the most abused, misused, and misunderstood. Not only that, our new research into changes both in the structure and participants in stock markets suggests that there may be greater opportunities for active managers to outperform in the future than in the past. This is true even in the most challenging of markets, the US.
What is the zero-sum game argument?
It can be explained as follows. Two types of investors make up the market, active and passive. Passive investors earn the market return. It follows that active investors, in aggregate, must also earn the market return because, when you combine the two, they must equal the market.
For any active investor to outperform, another has to underperform. They are fighting amongst themselves. And, because active managers charge higher fees than passive, active investors in aggregate have to underperform passive net of fees.
The logic is sound but how it is applied is where it often goes wrong.
What do people get wrong about the zero-sum game argument?
The first thing people often do is lump all passive investors on one side against active fund managers on the other. But the devil is in the detail. Technically, passive investors in the zero-sum game argument are those buying every stock in proportion to its market capitalisation weight. For example, if a stock is 5% of the market, it is 5% of your portfolio. In the zero-sum game argument, anyone who is not tracking the broad market in this way should go on the “active investor” side of the ledger.
It should be immediately obvious that this is not just active fund managers. So obvious, in fact, that, curiously, it is peddled so often as an academic-level critique of the active fund management industry.
Examples who fall into this category include anyone making sector, style, country, sustainability/ESG-driven, thematic, or other equity allocation decisions. Buy a technology ETF? In the zero-sum game, you are an active investor. The building blocks may be passive, but you end up with a portfolio that diverges from broad market weights. It also includes retail investors picking individual stocks. Meme stocks were an extreme example, but the point applies more generally.
In his original formulation of the zero-sum game argument, the famous academic William Sharpe (1991) himself states this explicitly, but many readers either don’t get this far through the article or choose to ignore it:
“active managers may not fully represent the "non-passive" component of the market in question…It is, of course, possible for the average professionally or institutionally actively managed dollar to outperform the average passively managed dollar, after cost”.
Another point worth noting is that the zero-sum game argument applies to the aggregate of all active investors. It does not mean that any subset of active investors, or even the average or median active investor cannot outperform passive.
None of this means that they will, of course. But it is not the mathematical impossibility that is often suggested.
What’s changed: the emergence of “neo-passive” investors
We could have made the arguments above at any time in history. But what has changed recently is the rise of investors who fall into this category of “active investors”, but who are not active equity fund managers. This is why we believe we can be more confident about the future prospects for active fund managers.
Firstly, there has been a proliferation of ETFs in recent years that do not track the broad market. We are calling these “neo passives”. In the US alone there are now over six times as many of these as traditional ETFs and inflows into these strategies have been 50% higher than traditional ETFs from the start of 2018 to the end of July 2024.
You can see the consequences by looking at how much these ETFs allocate to the largest stocks in the US market. The chart below shows this for the 10 neo-passive US equity ETFs which have attracted the greatest inflows in the five years to 30 September 2024. These 10 ETFs make up about half of all inflows to neo-passive ETFs over this period.
The breadth of active positioning is wide. The largest overweight holding in Apple is just over +2%, and the largest underweight is -7% (some don’t hold Apple at all).
Make no bones about it: the rise of neo-passive strategies results in active stock selection decisions, whether consciously or not.
What’s changed: the return of private stock pickers
Another shift is the rise of the retail investor. Hastened by the move to commission-free trading at a number of large US brokers (often through apps), individual investor participation in the stock market has surged. This trend accelerated during Covid-19 when many people found themselves with more time and money on their hands. The Gamestop saga brought discussions about trading and investing to the dinner table in many households.
In 2023, the number of individuals with trading accounts at a peer group of four major brokers was more than double the number from 2016.
While the number of monthly active users of the main broker apps has fallen from its covid-peak, it remains more than 60% above the level of 2018. Unlike many other post-pandemic trends, interest among Americans in investing has endured.
Of course, many of these individuals may just be buying S&P 500 ETFs, but the evidence suggests otherwise. Data from the Federal Reserve’s Survey of Consumer Finances shows that direct stock holdings as a share of total financial assets have increased close to levels not seen since the peak of the Dotcom bubble. This figure is directly held stocks only and does not include mutual funds or ETFs.
This survey only takes place every three years and we will need to wait until 2026 for the next set of results to be released. However, given the enthusiasm for the US Magnificent-71, it is easy to imagine that this line will have moved higher still in the intervening years.
Other issues: transactions
The other part of the zero-sum game argument that fails the “real world” test is the idea that any investor can truly be “passive” in the sense William Sharpe defines it. It simply isn’t possible to earn the market return by investing money in line with the weights of each stock in a given benchmark index, then going to sleep and letting the market do the rest.
What about initial public offerings? Or promotions or demotions from one market to another, such as large-cap vs small cap? Or other changes, such as MSCI’s decision a few years ago to increase the proportion of the market capitalisation of Chinese “A-shares” included in its main benchmarks?
All of these types of transactions create opportunities for a wealth transfer from passive investors to active. Active investors can trade in advance of index changes being implemented, then sell to passive investors when they become forced buyers. Index rebalancing leads to increased trading volumes and variability in the prices of affected stocks, popular for some active strategies to focus on. Active investors are also able to participate in IPOs, whereas passive typically do not, being forced to buy in the after-market. All trading incurs costs.
Whereas new entrants and exits from broad, developed market, large-cap, benchmarks are relatively low in number (with some exceptions, such as the IPO boom of 2021), they are a much bigger deal elsewhere. For example, small-cap benchmarks have much higher levels of index turnover (the percentage change in the composition of an index), as do emerging market and ESG indices.
This is an even bigger deal in bond markets than equities, as companies issue new bonds regularly. Keeping up with the changing composition of the index is one reason why many passive bond ETFs have a dreadful track record at tracking their benchmarks. One of the biggest high-yield debt ETFs has underperformed its benchmark by 0.6% p.a. over the five years to 31 December 2024, 0.9% p.a. over the 10 years, and by 1.5% p.a. since inception in 2007. These shortfalls are far greater than its expense ratio.
In summary
Many critics of active fund management use the zero-sum game to argue that it is mathematically impossible for active fund managers to beat passive, net of fees. This article hopefully demonstrates to you that this is categorically false.
Not only that. The rise in the number of investors and the value of investments that are not allocated according to broad market weights means we can be more optimistic about the future for active management than in the past.
It doesn’t mean that the average fund manager will go on to outperform but it does mean you shouldn’t automatically assume they can’t or won’t.
Now is the time to reconsider your beliefs about active and passive management, even in markets that you thought were “efficient”.
* Rymer is a senior strategist, strategic research unit, Exley is the head of specialist solutions and Lamont, is the head of strategic research at Schroders Investment Management.
PERSONAL FINANCE