Scale and Skill among Active Portfolio Managers

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...performance of a typical active mutual fund declines over time mostly because of the increasing scale of the fund industry.

Financial economists and industry officials have long studied and debated the extent to which the performance of actively managed mutual funds is affected by their size and by the skills of their managers. In Scale and Skill in Active Management (NBER Working Paper No. 19891), Lubos Pastor, Robert Stambaugh, and Lucian Taylor find that the growing size of the active mutual fund industry has had a significant negative impact on actively managed funds' performance. They also find that fund managers' skill has improved over time, yet average mutual fund performance has not. The reason is that skill has not improved quickly enough to offset the downward pressure from industry growth. The authors show that performance of a typical active mutual fund declines over time mostly because of the increasing scale of the fund industry.

To explore what determines returns on actively managed funds relative to passive benchmarks, the authors analyze performance and scale data from the Center for Research in Security Prices (CRSP) and Morningstar for 3,126 funds from 1979 through 2011. This is a period of tremendous growth for the mutual fund industry in general.

The study finds strong evidence of decreasing returns to scale at the industry level. The negative correlation between industry size and fund performance is more pronounced in funds with higher turnover and higher volatility, as well as in small-cap funds. "These results seem sensible since funds that are aggressive in their trading, as well as funds that trade illiquid assets, will see their high trading costs reap smaller profits when competing in a more crowded industry," according to the authors.

The authors also find that the skill of the active management industry has increased significantly over time, but the improvement in skill has failed to boost overall average fund performance over the years because of the steady growth of the industry's size. The authors measure skill by performance against passive benchmarks after adjusting for any adverse effects of fund or industry size.

Trends suggest that new active funds entering the industry are more skilled, on average, than the existing active funds. As a result, younger funds outperform older funds in a typical month. Indeed, funds up to three years old outperformed funds ten years and older by 0.9 percent a year. Funds aged between three and six years also outperformed the oldest funds.

-- Jay Fitzgerald