Opinion

James Saft

Managers improve, but scale kills

February 26, 2014

Feb 26 (Reuters) – Fund managers are getting better, but
active fund management is getting worse.

Yes, I realize that is a bit like saying improved medical
care is causing us to lose more patients, but this is indeed the
upshot of new research and it should put investors in a
quandary.

Researchers have found that skill levels among active money
managers are rising in a measurable way, but that performance
across the active industry as a whole as it increases in size is
declining.

The culprit: the sheer size of funds being managed.

“We consistently nd evidence of decreasing returns to scale
at the industry level,” Lubos Pastor of the University of
Chicago and Robert Stambaugh and Lucian Taylor of Wharton write
in a working paper released at the end of January. ()

In short, as the amount of money the industry as a whole is
given to manage rises, its ability to outperform fails to grow
due to more competition.

The paper, which analyzed actively managed U.S. equity
mutual funds, also found that funds with high turnover, higher
volatility and those which specialize in small-cap shares all
see diminishing returns as the industry grows in size.

What is truly ironic is that the data shows that active
managers are adding more alpha, or outperformance, over time.

Whereas the average fund in 1979 was producing 24 basis
points of outperformance attributable to skill per month, that
figure rose to 42 basis points in 2011. Among the top 10 percent
of managers by skill, extra monthly added value rose from 98
basis points in 1979 to 123 in 2011.

So if managers are getting better and better, how is it that
their relative results are getting worse and worse? Much of this
is driven by size. The authors estimate that for every 1 percent
increase in industry assets under management, active funds
suffer a loss of between 20 and 40 basis points of performance
per year.

“We argue that the 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.”

Take for example small-cap funds. Thirty or 40 years ago
there were fewer such funds, and fewer analysts covering those
companies. That created a happy hunting ground for those few who
did invest in small caps. But as their numbers swelled, much of
that advantage was arbitraged away.

GO YOUNG, YOUNG MAN?

The data suggests, the authors say, that new funds entering
the industry are more skilled, on average, than existing funds.
Younger funds are also outperforming older funds. In fact if you
divide the fund universe into groups by age, funds up to three
years old beat those which are more than 10 years old by a
statistically meaningful 0.9 percent per year. Funds which are
three to six years old also outperform the aged.

This trend is also seen within the life cycle of an
individual fund, with performance tending to deteriorate as the
fund ages, which somewhat undermines arguments that choosing a
fund with a long-established track record is a good strategy.

But before you go out and fire your old funds, note that the
authors find younger funds are capturing some of that
outperformance in the form of higher fees.

So why are younger funds better performers? The authors
speculate that it may be because younger managers are better
educated, or more able to use new technology. The technology
argument makes some sense. Funds based on new technology
designed to exploit algorithms and low-latency trading would
have been both new, and like the small-cap funds of long ago,
facing a playing field with little competition.

Those easy pickings, however, may well be competed away over
time.

It also seems likely, to me at least, that new funds are
more willing to try new techniques or strategies, and thus are
doing a better job of finding small areas where there are
pricing anomalies which can be profitable.

As we observe all the time at the company level, it is a lot
easier for a new entrant to try something new and radical than
it is for an established incumbent. In the same way, existing
funds tend to have an investment, at least psychologically, in
how they’ve always done things.

As those advantages are eroded by a growing industry, these
older funds are perhaps less likely to adapt.

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