Swedroe: Scale Works Against Active Skill

Studies show that while active manager skill is increasing, the effect is obliterated by growing scale.

An overwhelming body of evidence clearly demonstrates that past performance isn’t prologue, which presents a problem for investors who believe active management is the winning strategy. Without the ability to rely on past performance as a predictor, there is really no way to identify ahead of time the few active managers that will go on to outperform in the future.

There has been much debate in the literature, however, about why such a lack of persistence in performance occurs. Some believe it’s because the markets are highly efficient, or at least efficient enough to make it very difficult for skill differences to allow for repeat performances.

In my latest book, “The Incredible Shrinking Alpha,” which I co-authored with Bridgeway Capital Management Director of Research Andrew Berkin, we explain how four major themes—the conversion of what once was considered alpha into beta (or loading on a common factor) through academic research; the shrinking supply of victims active managers can exploit; the ever-tougher level of competition among active managers; and the increasing supply of capital chasing alpha—have all conspired against the quest to generate alpha.

A Study On Scale And Skill

Lubos Pastor, Robert Stambaugh and Lucian Taylor—authors of the study “Scale and Skill in Active Management,” which appeared in the April 2015 issue of the Journal of Financial Economics—provide important evidence to support the theme of increasing competition. The study covers the period 1979 through 2011 and more than 3,000 mutual funds.

The authors explain: “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.”

There are two explanations for negative returns to scale in active management. The first occurs at the fund level. A fund’s ability to outperform its benchmark declines as assets increase. As a fund becomes larger, its trades have a greater impact on prices, negatively affecting performance. The second occurs at the industry level. Increased competition for a limited amount of alpha reduces the ability of any given fund to outperform.

Scale And Returns

At the fund level, the authors found that “bias-free estimates consistently point to decreasing returns to scale … though we do not have enough power to establish their statistical significance.”

However, they did find consistent and statistically significant evidence of decreasing returns to scale at the industry level. According to the authors, “a larger industry features more competition among active funds, which impedes the funds’ performance.” They also discovered that 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 in less liquid assets, are likely to face larger price impact costs when competing in a more crowded industry. The authors then conclude: “Overall, our results strongly reject the hypothesis of constant returns to scale in active management.”

Increasing Industry Skill

The authors also came to the conclusion that fund managers have become more skillful over time: “We find that the average fund’s skill has increased substantially over time.” They then add: “The improvement in skill is steeper among the better-skilled funds. In short, active funds have become more skilled.” However, the authors also found that higher skill level has not been translated into better performance.

They reconcile the upward trend in skill with no trend in performance by noting that “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 is that the industry’s rising skill level was not due to rising skill within firms. Instead, the authors found: “The 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, the authors explain that “funds aged up to three years outperform those aged more than 10 years by a statistically significant 0.9% per year.”

They hypothesize that this is the result of managers at newer funds who are better educated or better acquainted with new technology, although they provide no evidence to support that thesis. The authors also found that all fund performance deteriorates with age as industry growth creates the problem of decreasing returns to scale and that newer, more skilled funds create more competition.

Another Perspective On Skill
The authors’ conclusion—that there is indeed rising skill in the active mutual fund industry—is consistent with the evidence from a 2009 study, “Wages and Human Capital in the U.S. Financial Industry: 1909-2006.”

The authors of that study, Thomas Philippon and Ariell Reshef, found that the levels of education, wages and the complexity of tasks performed by employees in the finance industry have increased steadily since 1980 relative to the rest of the private sector.

As discussed in “The Incredible Shrinking Alpha,” increasing numbers of highly skilled investment professionals have entered the competition for alpha over the last 50 years. They possess more advanced training, better analytical tools and faster access to more information than their predecessors.

Legendary hedge funds, such as Renaissance Technology, SAC Capital Advisors and D.E. Shaw, hire top mathematicians and computer scientists to assist them with their quest for alpha. MBAs and Ph.D.s from top schools, such as Chicago, Wharton and MIT, flock to investment management armed with powerful computers and massive databases.

Even investment firms that aren’t considered active are hiring managers with more talent. For example, Eduardo Repetto, co-CEO of Dimensional Fund Advisors (DFA), earned a Ph.D. from Caltech and worked there as a research scientist. DFA’s co-CIO, Gerard O’Reilly, also has a Caltech Ph.D., in aeronautics and applied mathematics. And my co-author, Andrew Berkin, has a Caltech B.S. and University of Texas Ph.D. in physics, and is a winner of the NASA Software of the Year award.

Thus, as author Charles Ellis—perhaps best known for the award-winning article “The Loser’s Game,” published in Financial Analysts Journal in 1975—noted, the unsurprising result of this increase in skill level is that “the increasing efficiency of modern stock markets makes it harder to match them and much harder to beat them, particularly after covering costs and fees.”

Pool Of Victims

It’s important to understand that for active managers to be successful, they must have a pool of victims 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 under management 20 years ago to about $3 trillion today), the number of victims (“dumb” retail money) available to exploit has been dramatically shrinking.

For instance, at the end of World War II, households held more than 90 percent of U.S. corporate equity. By 2008, it had dropped to around 20 percent. The financial crisis certainly did nothing to alter this trend. In short, the pool of money chasing alpha has been confronted with a shrinking number of victims.

There’s one more point worth covering. While the authors didn’t find statistically significant evidence of decreasing returns at the fund level, Jonathan Berk has provided important insight into the issue.

In his paper, “The Five Myths of Active Portfolio Management,” Berk suggested asking: “Who gets money to manage? Well, as 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 the manager’s ability to generate superior returns, and expected return will be driven down to the second-best manager’s expected return. At that point, investors will be indifferent between investing with either manager, 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 driven down to the expected return investors can expect to receive by investing in a passive strategy of similar riskiness (the benchmark expected return). At this point, investors are indifferent between investing with active managers or just indexing, and equilibrium is achieved.”

In summary, the authors of the study “Scale and Skill in Active Management” provide us with further evidence that the hurdles to successfully generate alpha are persistently rising. In addition, they provide additional explanation for why there’s so little evidence for the ability of active managers to generate persistence of outperformance beyond the randomly expected.

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