How the emergence of new investors creates opportunities for active to outperform

Andrew Rymer

Jon Exley

Duncan Lamont

Active managers have more opportunities to outperform than the popular "zero sum game" argument suggests. And the odds may be getting better.

Andrew Rymer, CFA, Senior Strategist, Strategic Research Unit
Jon Exley, Head of Specialist Solutions
Duncan Lamont, CFA, Head of Strategic Research

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. There are two types of investors who 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, it is curious that 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 which 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 which 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.

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