Can active work in a passive market?
Bottom-up investors are stuggling in a top-down world, but no trend lasts forever.
I meet our chosen fund managers all the time — part of our regime of half-yearly check-ups. Last month it was our UK equity managers’ turn, and we asked them what it takes to be a bottom-up stock picker in a market dominated by passive inflows and top-down themes.
We asked this for two reasons. Firstly, markets seem weird. Sometimes you can see this in the data, like the abnormal performance gap between the average fund and the market (see chart), or the valuation gaps opening up between large and small caps (which passive funds avoid). But other times it’s just a queasy sense that things are out of kilter.
And secondly, we were jolted by news that more US money is held in index funds than in active funds. And while the split in the UK still favours active, the flow away from active into passive is dramatic: Calastone data suggests £56bn has flowed into passive funds over the last three years, with £27bn flowing out of active funds. This is of market-warping size.
We asked our five UK equity managers — all proud fundamentals-based stock pickers — whether they shared our sense of ‘weirdness’ and, if they did, what does that look like?
All five agreed that today’s market is a different beast from the when they started out. They cited various causes, including passive dominance, Model Portfolio Service (MPS) consolidation, persistent active outflows, and platform and hedge fund behaviour. Additionally, some pointed to the as-yet-unknown impact of Artificial Intelligence.
Whatever the reason, they add up to the same thing: Market flows used to be background noise, but today they’re a primary driver of returns. Particularly in the smaller, less liquid parts of the market.
This interferes with their processes, which were designed before the recent changes in market action. They used to rely on getting their stock analysis right and spotting a mispriced company before the herd. But today this results in punishment, not reward, as flows continue to hammer a stock lower for longer.
If this sounds like whingeing, by the way, that certainly wasn’t their tone: All acknowledged the new reality with a pragmatic shrug, like a farmer accepting climate change.
This, of course, begged our next question: What, if anything, are they doing about it?
Here the answers varied. All agreed that liquidity is now poorer, and that holding concentrated positions is riskier.
Three of the five have become more wary of ‘momentum’, and while they haven’t changed their view of what’s an attractive stock, they are taking actions like hanging back before buying, or taking longer to build a position to full weight.
They’re keeping a closer eye on who else owns a stock too. If they know a stock has forced sellers (maybe a competitor’s fund that’s experiencing redemptions), they’ll hold off until that pressure abates.
The other two managers were less inclined to change their process. They believe that market timing is impossible to master, and that potentially deeper downdrafts are simply the price to be paid for steeper outperformance when the market swings back.
I don’t take sides in this debate. Both perspectives make sense, and only time will tell if one proves better than the other.
One area our managers did agree was the size of the opportunity in the UK market. Theirs is a target-rich environment. Small- and mid-caps are on historically wide discounts compared to large caps, and domestic cyclicals are already pricing in extremely negative economic outcomes. At some unknowable point they agree, UK small caps will make a lot of money.
These unusually attractive opportunities result from outflows from the usual holder base (active funds), as well as platform and MPS-driven selling. However, they will only be seized by those with patience, discipline, and tolerance of underperformance — a dwindling pool in the UK right now.
This chimes with the findings in a recent paper by AQR’s Cliff Asness. He acknowledges the risks of truly active management have risen, because nowadays you can look wrong for longer. But the yin to that yang is that opportunities have grown too: When the market does snap back to fair value, it’s got further to travel. This means greater returns for the patient investor.
This seems a fair summary: At a time when global equities look worryingly expensive, there are incredible gains to be made from undervalued UK mid and small caps. There are costs though, and these come in the form of an unappealing narrative and an uncomfortable wait.
The choice is yours.
This first appeared in Citywire magazine in May 2026.
Disclaimer
These are my own personal opinions for informational and educational purposes only and not financial advice. Nothing here should be treated as a recommendation to invest or take any specific action.
I’m not your financial adviser, and you should do your own research or seek professional advice before making decisions. Any reliance you place on this content is at your own risk, and I accept no liability for any losses incurred.
