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The Canadian Financial Advisor

The paradox of actively managed funds

Benjamin Felix

A recent paper by two Wharton professors and a colleague at the University of Chicago discusses the effects that the size of a mutual fund, the size of the fund industry, and fund manager skill have on the performance of actively managed mutual funds.  Historical data trends in these areas were studied to gain information on two hypotheses: as the size of an active fund increases, its ability to beat its benchmark decreases; and as the size of the active fund industry increases, the ability of any given fund to outperform the market decreases.  This study finds that fund size does not have a significant correlation with performance, but the size of the active fund industry does have a significant and negative correlation with performance.  A 1% increase in the size of the active fund industry was associated with an almost 40 bp decrease in the annual performance of the sample of funds examined.  This goes along with what we know from the Grossman-Stiglitz paradox; the more people that are trying to beat the market, the harder it is to get an information edge to beat the market.

Interestingly, the study found that the returns attributable to fund manager skill have increased over the period 1979-2011.  This increase in skill can be attributed to experience, education, or better use of technology. Increasing skill has not been evident in returns because returns have been hampered by growth of the active fund industry.  The study also found that the performance of a fund suffers as it gets older due to constant industry growth and the consistent introduction of more skilled competition.

This paper confirms what we already know about how competition drives the efficiency of markets.  As more entrants compete for alpha, it becomes more difficult to generate it.  It also tells us that although new funds may have increasingly skilled management, the positive effect of this skill decreases quickly in the first few years of the fund's existence.

If growth in the actively managed fund industry decreases the performance of actively managed funds, why would any investor continue to contribute their assets to actively managed funds?

"I want to invest in actively managed funds so that I can beat the market, but by investing in actively managed funds I am decreasing the chances that my actively managed fund will beat the market." It's a new paradox.

(Link to the paper)