Swedroe: The Problem Of Scope

The wider it gets, the more active manager performance suffers.

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.

Demiralp and Fernando concluded: “This implies that ex post performances of managers are not entirely due to luck, but managers possess some skill or some managers are skilled while others are not.”

Unfortunately, the authors also found that outperformance from individual managers is significantly more likely to be associated with an increase in the number of funds they are asked to manage—fund families take cross-sectional performance persistence into account when they decide to allocate more funds to their managers. That leads to the problem of expanded scope.

Demiralp and Fernando write that “performance drops significantly when managers run multiple funds, especially when these multiple funds have disparate objectives.”

'Siginificant Decline'

And when they focused on the top-performing managers in each category, they observed “a significant decline” in the average performance of managers running more than one fund, “which drops even further when those funds are from different objective classes.”

The authors continue: “For example, for the top 10 managers who manage one fund, the average benchmark-adjusted gross return (defining the benchmark-adjusted return as the fund return minus the return of the closest portfolio created from the set of Vanguard index funds) is 14.10%, which reduces to 7.79% when the managers run two or more funds in the same objective class. When the funds belong to different objective classes, the average benchmark-adjusted return drops even further, to 5.30%.”

In summary, Demiralp and Fernando confirm the evidence from prior research showing that successful active management tends to contain the seeds of its own destruction. That occurs as cash flows follow outperformance (leading to the well-documented problem of diseconomies of scale).

In addition, outperformance tends to lead to expanded manager responsibilities, resulting in the now-documented problem of diseconomies of scope. This all suggests that investors who continue to select actively managed funds should make sure they consider changing levels of assets under management and the number of funds a manager runs.

Diseconomies of scale and scope are not the only explanations for the difficulty that active managers have in delivering persistent outperformance. In our book, “The Incredible Shrinking Alpha,” my co-author Andrew Berki, and I provide four others.

Further Explanations

First, while markets are not perfectly efficient—as there are many well-known anomalies—they are highly efficient, and the anomalies can be exploited through low-cost, passive strategies that use systematic approaches to capture well-known premiums.

Academic research has been converting what once were sources of alpha—which active managers could exploit—into pure commodities, or beta (loading on some common factor, or characteristic).

For example, active managers used to generate alpha and claim outperformance simply by investing in small stocks, value stocks, momentum stocks and quality stocks. But that is no longer the case today, because investors can access these investment factors through passively managed vehicles.

Second, to generate alpha—which even before expenses is a zero-sum game—active managers must have a victim to exploit. And the supply of victims (retail investors) has been shrinking persistently since World War II.

Tougher Competition 

Seventy years ago, about 90% of stocks were held directly by individual investors. Today that figure is less than 20%. In addition, 90% or more of trading is done by institutional investors. Thus, the competition is getting tougher, as the supply of sheep that can be regularly sheared shrinks.

Third, the competition is much more highly skilled today. As Charles Ellis explained in Financial Analysts Journal, “over the past 50 years, increasing numbers of highly talented young investment professionals have entered the competition. … They have more-advanced training than their predecessors, better analytical tools, and faster access to more information.”

Fourth, there’s been a huge increase in the pool of assets chasing alpha. Consider that, just 20 years ago, hedge fund assets were in the hundreds of billions of dollars. Today they are about $3 trillion. Thus, you have many more dollars attempting to exploit a shrinking pool of alpha at the same time the competition has gotten much tougher. Not exactly a likely prescription for success.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.