Pedersen's article is titled Sharpening the Arithmetic of Active Management, in which he points out that William Sharpe's entire premise is only true in a world where the market portfolio itself is stable and never changes – which isn’t a reality, as companies issue and repurchase shares and the index market portfolio itself is reconstituted over time… which means even “passive” investors must regularly trade in the aggregate just to maintain a “market portfolio”, and at least run the risk that they may “passively” trade at inferior prices to active managers.
Of course, the caveat is that the impact of newly issued and repurchased shares, and the additions and subtractions from the index/market portfolio, can only create a positive active management opportunity if the changes are high-volume enough to allow an impact on the aggregate results. Yet Pedersen’s research suggests that this is in fact the case, given that IPOs in the primary market tend to sell at a discount relative to what they trade for in the secondary market when passive index funds would first get access to them (giving active managers an opportunity to better select the most winning IPOs before their market capitalization is clearly established by the market itself). Similarly, active managers can also trade in front of “known” index changes before they are implemented by passive funds, and because the “market portfolio” itself is still somewhat debated (market of US stocks? international stocks? also US bonds? international bonds? gold? commodities?), different active managers may fare better or worse by better selecting which “market portfolio” to own.
Accordingly, Pedersen suggests that a better way to recognize the distinction is that active managers play an important economic role – to help allocate resources efficiently in the economy, particularly as new companies/shares are issued or repurchased, which is an economic benefit to society, while the economic role of passive investing is more about simply creating low-cost access to markets for the mass of investors in the first place. Which means passive investing isn’t “bad”, but active managers aren’t necessarily doomed (or only subtracting value from the economy) either.