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The first level theory on indexing seems to be that with more people not even trying to outperform the index, it should be easier for active to outperform. That hasn't happened, and so the second level theory seems to be that with more people moving to indexing, that has left a more sophisticated pool of active investors. This makes things more competitive, and thus makes it harder to outperform. That seems like a reasonable theory to me, but I don't think it has been proven outside of a "theory" distinction.

Those kinds theories are cute but my guess is they're mostly unimportant. Most attempts to study crowd wisdom seem to hint that you don't need all that large of an N to reap most of the benefits of error canceling, and marginal changes in both crowd size and crowd skill aren't all that important as long as your group isn't too small or too dumb. Once you have some minimum level of brain diversity (reflecting both heuristics used and localized knowledge/approach) the only thing that really matters on the margin is maintaining relative independence; i.e. not seeing big changes in the tendency toward herd behavior. If I had to guess I'd say you could withstand pretty substantial swings in the pool and/or skill level of active investors due to indexing or semi-indexing without much of an overall efficiency impact.

On the other hand, I am not sure that the greater difficulty in outperforming in the recent past has been an indexing phenomenon, or at least an indexing-only phenomenon. Value stocks have taken it on the chin relative to growth in the last several years. Many value managers have done the same. I think this could simply be a temporary cycle. Of the mighty FANG stocks, I think at least the A and N are awfully tough to value.

When I talk about it getting tougher over time, I'm just throwing out an entirely subjective take from the trenches. Any resemblance to attempted measures of industry wide out-performance is coincidental. I'm not talking about value stocks under performing Netflix. I've just noticed it getting a bit harder to find really juicy stuff controlling for size/liquidity. I attribute most of this to the massive reduction in information frictions we've seen in the past couple of decades. Twenty years ago, it felt like you could somewhat reliably find smallish but far from microcap ideas where the "skilled" N really was small enough to matter. Obviously I never got everyone in a room and counted brains, but it was possible to see only 3-4 hits on a key PACER reorg document (of a company with equity value in the mid 10 figures) for days after it was posted. Management of a spinoff might tell you they'd only had six meetings/calls in total and four were with mutual funds who owned the parent and would probably just sell anyway. Information is such a virus though that it practically crawls out of those dark corners by itself these days, and the truly low N situations seem far less common and mostly relegated to smaller or less liquid ideas. That's far from saying the game is over, just an observation on the margins.
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