Are Active Mutual Funds Becoming Less Active?

February 19, 2013

 

Conclusion
It is impossible to pinpoint an exact reason why actively managed mutual funds are becoming less “active,” but the evidence would certainly suggest this is the case. One theory this author believes could be a driving force behind this change is increased movement to index investing. As more investors “index” their portfolios, more and more trading volume is based not on some technical analysis about the future earnings of a given company (for example), but instead whether or not a given security is included in a particular index (the S&P 500 in particular) and to what extent. Alternatively, it could be that “style purity” is becoming increasingly important for benchmarking purposes. Regardless of the reason, active funds have clearly become less active through time.

These findings present an interesting environment for active management. First, as more money flows to index funds, less money must be flowing to active strategies. Although active as well as passive investments can be “winners” from a positive flows perspective, the relative gain of either category definitely comes at the cost of the other. Second, if higher levels of flows into passive funds do create an environment that makes it more difficult for active management to outperform, and if an increasing amount of flows go to passive/index strategies, the ability of an active manager to outperform is likely to become increasingly hampered. Finally, for an efficient market to exist, there must be some active management. It is beyond the scope of this article to venture a guess as to where this point is, but we don’t appear to be there yet. It will certainly be interesting to see what happens if we do ever get there.

References
Investment Company Fact Book. 2011. http://www.ici.org/pdf/2011_factbook.pdf
Sharpe, William. 1992. “Asset Allocation: Management Style and Performance Measurement.” Journal of Portfolio Management, vol. 18 No. 2: 7-19
Sias, R.W., L. Starks and S. Titman. 2006. “Changes in Institutional Ownership and Stock Returns: Assessment and Methodology.” Journal of Business, vol. 79 No. 6:2869-2910.
doi:10.1086/508002
Sullivan, R. and Xiong, J. X. 2012. “How Index Trading Increases Market Vulnerability.” Financial Analysts Journal. Forthcoming, available at SSRN: http://ssrn.
com/abstract=1908227

Endnotes
1 Sullivan and Xiong [2012]
2 Sias, Starks and Titman [2006]; Sullivan and Xiong [2012]
3 Both explicit management fees and implicit fees that result from trading, such as the bid/ask spread and commissions

Find your next ETF

Reset All