Passive Investing, Mutual Fund Skill, and Market Efficiency

This paper examines how the rise of passive investing affects active management. I develop a parsimonious model of passive and active investment in which greater passive investment accelerates investors' learning about active managers' skill. The model provides a rational explanation, namely the rise of passive investing, for several empirical observations: A more skilled active mutual fund industry, more closet indexing by active funds, and compression of the performance distribution of active investing. I test the model's predictions using a novel shift-share instrumental variable design and show they are borne out in the data. I also find that high levels of passive investing improve market efficiency, consistent with a more skilled active mutual fund industry.