Decreasing Returns To Scale In Actively Managed Mutual Funds

by: Larry Swedroe


The past performance of active managers is no predictor of their future performance.

Study: Decreasing economies to scale can explain the lack of persistence in performance among active managers.

Fund managers have become more skillful over time, but this higher skill level has not been translated into better performance.

An overwhelming body of evidence demonstrates that the past performance of active managers is no predictor of their future performance. Because past performance isn't prologue, there's really no way to identify those few winners among active managers ahead of time.

Why there's such a lack of persistence in performance has become a topic of much debate. Some believe that it's a result of the markets being highly efficient, or at least efficient enough to make it very difficult for skill differences to allow for repeat performances.

But professors Lubos Pastor, Robert F. Stambaugh and Lucian A. Taylor, authors of the August 2013 paper, "Scale and Skill in Active Management," provide another explanation: decreasing economies to scale. They write:

"The extent to which an active fund can outperform its passive benchmark depends not only on the fund's raw skill in identifying investment opportunities but also on various constraints faced by the fund. One constraint discussed prominently in recent literature is decreasing returns to scale. If scale impacts performance, skill and scale interact: for example, a more skilled large fund can underperform a less skilled small fund."

The literature provides us with two explanations for negative returns to scale in active management. The first is at the fund level, where a fund's ability to outperform its benchmark declines as its assets increase. The larger a fund, the greater the impact its trades have on prices, which negatively effects performance. The second is at the industry level, where increased competition for a limited amount of alpha reduces the ability of any given fund to outperform.

That being said, the authors -- whose study covered the period from 1979-2011 and more than 3,000 mutual funds -- were unable to find reliable evidence of decreasing returns at the fund level. However, they did find consistent and statistically significant evidence of decreasing returns to scale at the industry level, which they connect with the industry's growth in size. They explain:

"The negative relation between industry size and fund performance is stronger for funds with higher turnover, higher volatility, as well as small-cap funds. These results seem sensible since funds that are more aggressive in their trading, as well as funds that trade less liquid assets, are likely to face larger total price impact costs when competing in a more crowded industry."

The authors conclude that fund managers have become more skillful over time: "We find that the average fund's skill has increased substantially over time, from -5 basis points (BP) per month in 1979 to +13 bp per month in 2011." However, they also note that this higher skill level has not been translated into better performance. Pastor, Stambaugh and Taylor reconcile the upward trend in skill with no trend in performance by arguing:

"Growing industry size makes it harder for fund managers to outperform despite their improving skill. The active management industry today is bigger and more competitive than it was 30 years ago, so it takes more skill just to keep up with the rest of the pack."

Another finding of interest was that rising skill level in the active management industry overall was not due to rising skill in firms. Instead, "new funds entering the industry are more skilled, on average, than the existing funds. Consistent with this interpretation, we find that younger funds outperform older funds in a typical month." For example, "funds aged up to three years outperform those aged more than 10 years by a statistically significant 0.9% per year." The authors hypothesize that this is the result of newer funds having managers who are better educated or better acquainted with new technology, though they provide no evidence to support that thesis. They also found that all fund performance deteriorates with age as newer and more skilled funds create additional competition.

It's important to understand that for active managers to be successful, they must have victims that they can exploit. The problem is that while the active management industry has grown tremendously over the past 60 years -- hedge funds alone have gone from about $300 billion in assets 20 years ago to more than $2.6 trillion now -- the pool of victims ("dumb" retail money) available to exploit has been dramatically shrinking. At the end of World War II, households held more than 90 percent of U.S. corporate equity. By 2008, it had dropped to about 20 percent. The financial crisis certainly did nothing to alter the trend, and the pool of money chasing alpha has been confronted with a shrinking pool of victims.

While Pastor, Stambaugh and Taylor didn't find reliable evidence of decreasing returns at the fund level, it's worth considering this insight from Jonathan Berk in his paper, "Five Myths of Active Portfolio Management." Berk suggested asking:

"Who gets money to manage? Well, since investors know who the skilled managers are, money will flow to the best manager first. Eventually, this manager will receive so much money that it will impact his ability to generate superior returns and his expected return will be driven down to the second best manager's expected return. At that point investors will be indifferent to investing with either manager and so funds will flow to both managers until their expected returns are driven down to the third best manager. This process will continue until the expected return of investing with any manager is the benchmark expected return - the return investors can expect to receive by investing in a passive strategy of similar riskiness. At that point investors are indifferent between investing with active managers or just indexing and an equilibrium is achieved."

In summary, Pastor, Stambaugh and Taylor in "Scale and Skill in Active Management" deliver further evidence that the hurdles to successfully generating alpha are getting ever higher. They also provide additional explanation for why there's so little evidence on the ability of active managers to perform beyond the randomly expected.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.