Swedroe: Scale’s Effect On Active Performance

January 18, 2017

However, Evans, Gil-Bazo and Lipson then demonstrated that instead of such expanding scope leading to superior performance, it negatively impacts subsequent performance even after controlling for effects related to fund size. Their results were robust to various tests. It serves as yet another example of successful active management sowing the seeds of its own destruction and the Peter principle (which posits that managers rise to the level of their incompetence) at work.

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

The authors 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.”

More Explanations
There are yet other explanations for the difficulty that active managers have in delivering persistent outperformance beyond the problems of scale and scope. In our book, “The Incredible Shrinking Alpha,” Andrew Berkin and I provide four other 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. 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.


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