Scale and Skill in Active Management

Abstract

We empirically analyze the nature of returns to scale in active mutual fund management. We find strong evidence of decreasing returns at the industry level. As the size of the active mutual fund industry increases, a fund‫׳‬s ability to outperform passive benchmarks declines. At the fund level, all methods considered indicate decreasing returns, though estimates that avoid econometric biases are insignificant. We also find that the active management industry has become more skilled over time. This upward trend in skill coincides with industry growth, which precludes the skill improvement from boosting fund performance. Finally, we find that performance deteriorates over a typical fund‫׳‬s lifetime. This result can also be explained by industry-level decreasing returns to scale. We empirically analyze the nature of returns to scale in active mutual fund management. We find strong evidence of decreasing returns at the industry level: As the size of the active mutual fund industry increases, a fund's ability to outperform passive benchmarks declines. At the fund level, all methods considered indicate decreasing returns, though estimates that avoid econometric biases are insignificant. We also find that the active management industry has become more skilled over time. This upward trend in skill coincides with industry growth, which precludes the skill improvement from boosting fund performance. Finally, we find that performance deteriorates over a typical fund's lifetime. This result can also be explained by industry-level decreasing returns to scale.

Presidential Address: Investment Noise and Trends

“…The model of Berk and Green () features decreasing returns to scale, and a number of studies have investigated the presence of fund‐level decreasing returns to scale using mutual fund data. Pástor, Stambaugh, and Taylor () report evidence consistent with fund‐level decreasing returns, though not with strong statistical significance when employing methods that avoid econometric biases . Edelen, Evans, and Kadlec () conclude that trading costs present an important source of scale diseconomies for mutual funds.…”

“…One can interpret this value in the context of the implied separate value for c by conditioning on M in that same mid‐sample year. To get a rough estimate of M , I add the number of active mutual funds in the data set constructed by Pástor, Stambaugh, and Taylor () to the number of institutions other than mutual funds filing Form 13F with the SEC, as provided by Thomson Reuters. In 1996 this estimate of M equals 2,212, giving an implied value of .…”

“…Actively managed equity mutual funds—the segment of active management for which returns data are most available—have historically provided investors with net average returns below those on passive benchmarks. For example, the value‐weighted portfolio of the actively managed mutual funds in the data set constructed by Pástor, Stambaugh, and Taylor () has an annualized estimated net alpha equal to −0.31% ( t ‐statistic: −1.06) for the 1980–2011 period…”

“…Active management lost market share to indexing while also becoming more similar to indexing as an investment. For example, Panel C of Figure displays the history since 1980 of the index tracking error for the aggregate portfolio of actively managed equity mutual funds in the data set constructed by Pástor, Stambaugh, and Taylor (). The value plotted for a given year is the annualized standard deviation of the market‐adjusted monthly return for the subsequent 60 months.…”

Mutual Fund Flows and Cross‐Fund Learning within Families

“…() and Yan () find that fund size erodes fund returns. Pástor, Stambaugh, and Taylor () find evidence of industry‐level decreasing returns in mutual fund management.…”