Explaining decreasing returns to scale in active management

By LARRY SWEDROE

One of the problems for those who believe active management is the winning strategy is that there’s an overwhelming body of evidence demonstrating that the past performance of active managers isn’t prologue. Without the ability to rely on past performance as predictor, there’s really no way to identify the few future winners ahead of time.

There has been much debate in the literature about why there’s such a lack of persistence in performance. Some believe it’s a result of the markets being highly efficient, or at least efficient enough to make it very difficult for skill differences to allow for repeat performances. My book The Incredible Shrinking Alpha, co-authored with Andrew Berkin, the director of research at Bridgeway Capital Management, explains how four major themes—academic research converting what was once alpha into beta (or loading on a common factor), the shrinking supply of victims that can be exploited, tougher competition, and the increasing supply of capital chasing alpha—have been conspiring against the ability to generate alpha.

Lubos Pastor, Robert F. Stambaugh and Lucian Taylor, authors of the study Scale and Skill in Active Management, which appears in the April 2015 issue of the Journal of Financial Economics, provides evidence that supports the theme of increasing competition. The study covers the period 1979-2011 and over 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 is at the fund level—a fund’s ability to outperform its benchmark declines as its assets increase: the larger a fund, the greater the impact of its trades on prices, negatively impacting performance. The second is at the industry level, as increased competition for a limited amount of alpha reduces the ability of any given fund to outperform.

Scale and returns

Pastor, Stambaugh and Taylor found that “Bias-free estimates consistently point to decreasing returns to scale at the fund level, 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: “A larger industry features more competition among active funds, which impedes the funds’ performance.” They also found: “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 less liquid assets are likely to face larger price impact costs when competing in a more crowded industry. They concluded: “Overall, our results strongly reject the hypothesis of constant returns to scale in active management.”

Increasing industry skill

The authors also concluded, “We find that the average fund’s skill has increased substantially over time.” They added, “The improvement in skill is steeper among the better-skilled funds. In short, active funds have become more skilled over time.” However, they also found that the higher skill level has not translated into better performance. They reconcile the upward trend in skill with no trend in performance by noting: “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 was that the rising skill level was not due to rising skills within firms. Instead, they 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, they found, “Funds aged up to three years outperform those aged more than 10 years by a statistically significant 0.9% per year.” The authors hypothesised that this is the result of newer funds having managers who are better educated or better acquainted with new technology—though they provided no evidence to support that thesis. The authors also found that all fund performance deteriorates with age as the industry growth creates the problem of decreasing returns to scale, and newer more skilled funds create more competition.

The authors’ finding of rising skill in the active mutual fund industry is consistent with the evidence from the 2012 study Wages and Human Capital in the U.S. Finance Industry: 1909-2006. The authors, 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, over the past 50 years increasing numbers of highly skilled investment professionals have entered the competition. They have more advanced training, better analytical tools and faster access to more information than their predecessors. And legendary hedge funds, such as Renaissance Technology, SAC Capital Advisors and D.E. Shaw, hire Ph.D. scientists, mathematicians and computer scientists to aid in 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 managers are hiring managers with more talent. For example, Dimensional Fund Advisors’ CIO Gerard O’Reilly 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 Charles Ellis noted, the unsurprising result of this increase in skill 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

An important issue to understand here is that, for active managers to be successful, they must have 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 20 years ago to about $3 trillion today — the pool of victims (“dumb” retail money) it can exploit has been dramatically shrinking. 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 the trend. The bottom line is that the pool of money chasing alpha has been confronted with a shrinking pool of victims.

Before summarising, 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 provided important insights into the issue in his paper The Five Myths of Active Management. Berk suggested asking: “Who gets money to manage? Since investors have access to databases that provide returns histories, and everyone wants to have their money managed by the best manager, money will flow to the best manager first. Eventually, the best manager will receive so much money that it will impact his ability to generate superior returns and his expected return will be driven down to the second best manager’s expected return. At that point investors will be indifferent to investing with either manager and 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 the benchmark expected return — the return investors can expect to receive by investing in a passive strategy of similar riskiness. At that point investors are indifferent between investing with active managers or just indexing and an equilibrium is achieved.”

Summary

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