Swedroe: Scale’s Effect On Active Performance

January 18, 2017

Investors Undermine Performance
Berk and Green explain that, in their model, “ … investments with active managers do not outperform passive benchmarks because investors competitively supply funds to managers and there are decreasing returns for managers in deploying their superior ability. Managers increase the size of their funds, and their own compensation, to the point at which expected returns to investors are competitive going forward. The failure of managers as a group to outperform passive benchmarks does not imply that they lack skill. Furthermore, the lack of persistence does not imply that differential ability across managers is unrewarded, that gathering information about performance is socially wasteful, or that chasing performance is pointless. It merely implies that the provision of capital by investors to the mutual fund industry is competitive.”

Berk and Green continue: “Performance is not persistent in the model precisely because investors chase performance and make full, rational use of information about funds’ histories in doing so. High performance is rationally interpreted by investors as evidence of the manager’s superior ability. New money flows to the fund to the point at which expected excess returns going forward are competitive. This process necessarily implies that investors cannot expect to make positive excess returns, so superior performance cannot be predictable. The response of fund flows to performance is simply evidence that capital flows to investments in which it is most productive.”

Harvey and Liu also found that industry-level scale had a significant impact, estimating that a 1% increase in industry scale implies a 0.05% drop in per-year alpha for the average fund. They concluded that the impact of scale at the individual fund level is higher (more than twice as high, in fact) than at the industry level.

They added that the impact of fund size can be estimated with a much higher precision than the impact of industry size (the 90% confidence ranges were much tighter for fund size).

Scale Isn’t The Only Issue

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

The authors investigated the changes in the performance of mutual fund managers that result from alterations in the scope of their duties.

First, as we would expect, they confirmed that the scope of manager responsibilities is expanded in response to positive past performance. They found that managers with higher relative four-factor (beta, size, value and momentum) alphas see 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 their scope of responsibilities.


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