Managers improve, but scale kills
Skill levels among fund managers rising, but industry-wide performance declining, says James Saft.
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 ﬁnd 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 analysed actively managed US 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 24bp of outperformance attributable to skill per month, that figure rose to 42bp in 2011. Among the top 10% of managers by skill, extra monthly added value rose from 98bp in 1979 to 123bp 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% increase in industry assets under management, active funds suffer a loss of between 20bp and 40bp 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% 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.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)