A recent paper, Scale and Skill in Active Management, finds that as the mutual fund industry grows larger, it is more difficult for actively managed funds to outperform their benchmark indexes. The paper finds that the decline in performance is true both at the individual fund level and at the industry level. The decline occurs even as skill (defined in the paper as gross alpha earned on the first dollar invested in a fund with no other funds in the industry) increases over time. The paper examines data from 3126 funds over the period from 1979 – 2011.
The paper identifies liquidity constraints as one reason for the decline in performance that occurs at both the individual fund level as well as the industry level. For example, as a fund increases in size, its portfolio trades have a greater impact on the prices in the market causing downward pressure on fund performance. At the industry level, as more managers seek opportunities in the market, fewer such opportunities exist. The paper finds that the relation between industry size and performance is even stronger for funds with higher turnover, higher volatility, and small cap funds.
The paper also examines the performance of funds over time, finding that newer funds outperform older funds on a gross return basis. For example, funds that are less than three years old outperform funds older than 10 by 0.9% per year (though the outperformance is smaller on a net basis). Similarly, even over an individual fund’s lifecycle, a fund performs better when it is newly introduced; the decline in performance of an individual fund also is attributed to industry growth of a fund’s life.
While the paper finds that the skill level in the industry has increased over time, the increase in skill is necessary to merely keep up with the industry rather than increasing the likelihood of outperformance. However, the paper does find that increasing skill level can reduce, but not eliminate, the negative impact of industry growth.