Competing Against Less-Skilled Investors

The massive shift in asset allocation away from active investing towards passive investing exacerbates this effect. Thirty years ago, index funds were less than one percent of assets under management, and today they (along with other passive vehicles such as exchange-traded funds) are about one-third. Think of it this way: For you to have positive alpha, the industry’s term for risk-adjusted excess return, someone has to have negative alpha of the same amount. By definition, alpha for the market must equal zero (before fees).

So you want to compete against less-skilled investors because they are your source of alpha. It is disadvantageous for you if the weak players flee the market (selling their stocks and buying index funds), or if the least capable professional investors lose assets to passive funds, because it means that only the smartest investors remain in the active game. The truth is that weak players. whom the strong players require to generate excess returns, are fleeing at a record pace.

– Michael Mauboussin