I’d like to start this month’s commentary with a moment of silence for the actively managed investment industry. Net client cash flows have been negative since 2004 for actively managed mutual funds, and the latest Morningstar data offers no relief on that front. Investors withdrew $340 billion from actively managed funds and deposited more than $504 billion into passive strategies in 2016, turbocharging the recent trend. Decades of underperformance and high fees are certainly taking their toll.

Study after study continues to show significant underperformance against passively managed funds for almost any time period or asset class. Focusing on recent performance, a Morningstar study released in 2015 showed that active managers in aggregate beat their benchmark indexes less than 50% of the time in 11 of 12 asset classes studied over the 10 years ended 2015. They found that 78% of US large stock managers, 60% of foreign developed stock managers and 63% of emerging market managers underperformed their benchmarks over that period. Importantly, the study also found that the performance of the highest cost funds was materially worse than those in the lowest cost category. In other words, the degree of underperformance was directly related to the level of fees charged. It seems that investors did not get what they paid for.

Should investors be surprised by these poor results? Not really – in fact this outcome was predicted quite accurately in a very short article published 26 years ago in The Financial Analysts’ Journal. In “The Arithmetic of Active Management”, author Bill Sharpe explained how in a world populated by “active” and “passive” investment managers, the aggregate performance of the active managers must equal the passive manager’s performance, minus the difference in fees. Why? Because before fees, “passive” managers, by definition, will hold a pro-rata slice of all securities in the market and thus obtain the exact return of the market itself.

What’s left then for active managers? Simple – they also obtain the return of the market, in aggregate, before fees. Mathematically, you can see that this must be true. Ignoring fees, if the “market” return (M) equals the sum of all investors’ individual performances (both passive and active), you can express the simple equation this way:

Market return (M) = Active Return (A) + Passive Return (P)

Here’s the magic: since the passive performance equals the market performance, they, in effect, cancel each other out. Now the equation collapses to M = A, suggesting that active managers must also earn the market return, because that’s all that’s left! And after deducting their [higher] fees, they will necessarily underperform passive strategies, by the amount of their extra fees. The argument is as beautiful as it is simple.

Now when Bill Sharpe wrote his essay in 1991, it was reasonable to simplify his argument by assuming the investment world split neatly into active and passive camps. But today, a relatively new type of investment manager is growing in popularity and competing with traditional active and passive strategies. I’m referring to evidence-based investing in particular (“factor-based” investing more broadly) and I would argue that it now constitutes a legitimate third category of asset manager. So, it may be more accurate to assume we now inhabit an investment world populated by three types of managers – active, passive, and factor-based.

Due to this recent development, the prospects for traditional active managers may now dim even further. Why is that? Remember – factor-based investors “enhance” passive returns by tilting their portfolios toward a few known risk factors, such as low-priced, small or highly profitable companies. By doing so, they earn higher than market returns over the long term. Where will these higher returns come from? I believe Bill Sharpe already answered this question in 1991 – and if we follow his logic, we know it can’t come from the passive managers, who always earn the market return. Active managers are the only category left.