Swedroe: The Problem Of Scope

September 22, 2017

There is a large body of overwhelming evidence that shows past performance is, at best, a poor predictor of active managers’ future performance, and many explanations for the difficulty that active managers face in delivering persistent outperformance.

Among them is that there are well-documented diseconomies of scale regarding trading costs (and problems associated with closet indexing for active managers seeking to minimize those trading costs), which sow the seeds of destruction for even successful managers as their performance attracts new assets.

Digging Deeper

Unfortunately, diseconomies of scale aren’t the only problem for successful actively managed funds. Richard Evans, Javier Gil-Bazo and Marc Lipson, authors of the November 2016 study “Diseconomies of Scope and Mutual Fund Manager Performance,” offer another explanation for this lack of persistence. Their study covered the U.S. fund industry during the period 1997 through 2015 and about 10,000 mutual funds.

The authors investigated changes in fund managers’ performance that result from alterations in the scope of their duties. First, as we would expect, the authors confirmed that the scope of manager responsibilities expands in response to positive past performance.

They found that managers with higher relative four-factor (beta, size, value and momentum) alphas undergo an expansion in the scope of their responsibilities, defined as an increase in the number of funds under control or an increase in the total size of assets under management following a change in control (a reallocation of funds) that keeps the number of funds constant. They also found that managers with lower relative alphas see a similarly defined contraction in the scope of their responsibilities.

Negative Performance

However, Evans, Gil-Bazo and Lipson then showed that, instead of leading to superior performance, expanding scope negatively impacts subsequent performance even after controlling for effects related to fund size.

Their results were robust to various tests, and serve as yet another example of successful active management sowing the seeds of its own destruction, as well as the Peter Principle (which posits that managers rise to the level of their incompetence), at work.

It is also worth observing that the authors found symmetry in their results insofar as that, after a reduction in scope, the poor performance of ostensibly worse managers is curtailed, thus providing further support to the scope hypothesis.

Finally, they concluded: “Our results suggest a significant diseconomy of scope exists with respect to performance similar to the diseconomies of scale previously highlighted and that, together, these two effects may explain the observed attenuation over time in abnormal relative mutual fund returns.”

Supporting Evidence On The Impact of Scope

Ilhan Demiralp and Chitru Fernando contribute to our understanding of the impact of scope on fund performance with their March 2017 study, “An Assessment of Managerial Skill Based on Cross-Sectional Mutual Fund Performance.”

As was the case with Evans, Gil-Bazo and Lipson’s study, Demiralp and Fernando used fund managers instead of funds as their unit of observation. The study covers the period January 1992 to June 2014, and their findings support Evans, Gil-Bazo and Lipson’s, while also providing some new information.

To measure the cross-sectional persistence of a manager’s performance, Demiralp and Fernando calculated the standard deviation of the performance rank of that manager’s funds in excess of the standard deviation obtained from a hypothetical sample of managers with no skill.

Interestingly, they found that whether performance was measured against a benchmark index fund or four-factor (beta, size, value and momentum) alpha, the cross-sectional persistence of manager performance was larger than would be observed if managers had no skill, suggesting managers’ observed performance can’t be explained by luck alone. They also found that this cross-sectional persistence continues for at least six years.

 

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