Some financial advisors won’t touch a mutual fund until it sports a three-year track record. But maybe they should, because by that point a fund’s best days might already be behind it.
According to a study by three academics writing for the National Bureau of Economic Research, younger funds tend to outperform older funds, even though active management as a whole is negatively affected by the ever-expanding size of the mutual fund industry.
In the paper, titled Scale and Skill in Active Management, University of Chicago professor Lubos Pastor and University of Pennsylvania professors Robert Stambaugh and Lucian Taylor examined performance and scale data from Morningstar and the Center for Research in Security Prices for 3,126 funds from 1979 through 2011.
They posit that active management today is better than ever, but that there’s more to beating a passive benchmark than just a manager’s raw skill at finding investment opportunities. Various factors can impact a fund’s performance, such as scale. One school of thought holds that there’s an inverse relationship between a fund’s size and its performance because larger funds can’t trade as nimbly in the market.
The research suggests that industry scale has a bigger impact on performance than fund scale, according to the authors. And the negative relationship between industry size and fund performance is strongest for funds with higher turnover and higher volatility and for small-cap funds.
But the professors don’t supply a cause and effect to explain why average performance at active funds has failed to improve as the mutual fund industry grows.
“We do not establish causality; we simply refer to the negative size-performance relation as decreasing returns to scale,” the report said.
Regarding manager skill levels (as measured by a fund’s gross alpha before its scale-related erosion), the professors argue that the observed improvement among active fund managers is mainly due to newer managers who are better educated or more familiar with new technology.
“We find that young funds tend to outperform their older peers, consistent with the new entrants being more skilled,” the report said. “However, as funds grow older, their performance tends to deteriorate due to continued industry growth and the associated arrival of skilled competition.”
The report asked whether actively managed funds do better overseas in countries with smaller active management industries. It cited “suggestive evidence” from another research team’s report last year that active funds perform better outside the U.S.—especially in emerging markets where there’s less competition among active managers.
Small Is Better With Active Management
August 2014
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