Source: Evidence Investor
Absolute skill may be necessary for success as an active manager, but it is not sufficient. It’s relative skill that determines outperformance and underperformance. It’s not enough to be good at valuing companies; a successful active manager has to be better than his competitors.
If investment management is not unique in this respect, it at least is highly unusual. An average physician may be able to cure most illnesses, and an average lawyer may be a perfectly adequate source of legal representation for most needs. However, investment management is different: an average investment manager is of no value at all. Investing is unusual, in that the collective judgement of all the participants (weighted by the amount of money they control) is… available for free… If a professional investor is to earn excess returns for his client, being good is insufficient — he must be exceptional.
The difficulty is compounded when we consider what happens when assets move from active managers to index funds. Presumably, the least capable active managers lose the most assets. This means that the quality of the surviving active managers rises as assets move to passive alternatives, making the competition for outperformance tougher. Active managers thus find it increasingly difficult to stay above average as index funds cull the weakest competitors.