Connecting decision makers to a dynamic network of information, people and ideas, Bloomberg quickly and accurately delivers business and financial information, news and insight around the world. Passive investing is eating the mutual-fund industry, as money floods out of actively managed funds and into index funds and exchange-traded funds.

Active funds are supposed to make money by concentrating their investments and taking advantage of good opportunities. The case for passive investing is that active investing is a losing game.

The market is just too efficient -- efforts to beat it cost time and money but produce little in the way of extra risk-adjusted returns. Better to ride the average with an index fund or ETF than waste time trying to out-think the crowd. For individual investors -- folks picking stocks at home with their own money -- the academics are giving very good advice.

Only a very small percentage of normal people -- perhaps 2 percent to 5 percent -- have the skill to consistently beat the market average, after adjusting for risk.

Indexing vs. Stock Picking: Which is Better Right Now? | Investopedia

Professionals, however, are a different matter. A large number of studies has documented that the typical mutual fund manager really does have the skills to beat the market on average. Now, via finance professors Lubos Pastor, Robert Stambaugh and Lucian Taylor, there is more evidence that professional money managers are very different from their amateur counterparts.

If fund managers have market-beating skill, their trades should come from spotting real opportunities instead of mirages, so they should make higher returns just after an unusually large burst of trading -- assuming, of course, that their trades pay off within a year.

In general, trading isn't correlated with higher or lower returns.

But for each specific fund, higher-than-average trading is followed by higher-than-average returns. That means that although not all trading is based on good opportunities, a lot of it is. When there are chances to beat the market, money managers tend to see them and take them.

Picking Stocks vs Investing In Index Funds

Most of these opportunities are not the kind of thing that finance professors could observe directly in the data if they were, more professors would be managing funds. But Pastor et al.

Finance researchers know about a number of anomalies -- signals that assets are mispriced. So money management skill is real. But does this mean that active management is underrated, and the stampede into index funds and ETFs is overdone? The first reason is diminishing returns -- a phenomenon many investors know as crowding. Even more importantly, they find that larger funds have a weaker relationship between trading and performance -- meaning that the less money you manage, the easier it is to find profitable investments.

The second reason is fees. Mutual funds with better trading ability tend to charge higher fees, which makes sense. So although there is real value in active management, the industry is probably too big. Gigantic funds are finding it harder to spot profitable trades.

Index Funds vs. Stock Market

And most active funds charge investors too much. Therefore, the exodus from active management still makes sense. Eventually, if it continues, active managers will shrink in size and drop their prices, and balance will be restored. This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners. To contact the author of this story: Noah Smith at nsmith bloomberg. To contact the editor responsible for this story: James Greiff at jgreiff bloomberg.

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Forget stock picking, stick with the indexes - MarketWatch

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Smart money managers outperform the market. But their fees are too high and investors are better off in passive funds. Clear thinking from leading voices in business, economics, politics, foreign affairs, culture, and more. Before it's here, it's on the Bloomberg Terminal. Noah Smith is a Bloomberg View columnist.

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