00:00:05
our paper is about scale and skill and active management we started with a simple idea which is that a mutual
00:00:12
fund's performance depends not just on skill but also potentially on scale so
00:00:18
in order for us to say anything about scale we need to make sure we first understand scale so the goal of this
00:00:24
project is is to understand the nature of returns to scale an active mutual fund management
00:00:30
we test two different ideas the first is decreasing returns to scale at the fund
00:00:35
level there the idea is as a fund gets larger that causes the fund's performance to to drop for example
00:00:43
because larger funds make larger trades that push prices more and that hurts performance that's the first idea the
00:00:51
second idea is decreasing returns to scale at the industry level the idea here is as the overall mutual fund
00:00:58
industry gets larger that makes all funds performance decrease and here the logic is as there are more mutual fund
00:01:06
dollars out there competing and chasing after mispriced stocks that makes prices
00:01:11
move and it makes harder for any mutual fund to find a a good trading opportunity our main result is strong
00:01:18
evidence of decreasing returns at the industry level in contrast we find mixed evidence of decreasing returns at the
00:01:26
fund level so more simply we find that it's the size of the mutual fund industry that's very important for
00:01:32
performance the size of an individual fund is less important these results that we're finding on scale have some
00:01:40
interesting implications for how we think about skill we offer a new way of measuring skill that adjusts for scale
00:01:48
with this measure we show for example that uh skill has been trending upwards uh in the mutual fund industry over the
00:01:54
last 30 years well an active mutual fund is U distinguished from a passive mutual fund
00:02:05
in the sense that a passive mutual fund would just buy a basket of stocks that represent an overall investment in the
00:02:12
stock market or segment of the stock market what we typically call an index fund uh an active fund deviates from
00:02:19
that from that portfolio by overweighting stocks that it believes are underpriced and offer Superior
00:02:27
returns and uh down weights or sells off the stocks that it believes are overpriced or or offer worse returns uh
00:02:35
so an active fund will uh trade more than uh a passive fund and its return will have what we call tracking error
00:02:44
relative to the passive uh uh Benchmark against which it's judged well the Surge and popularity of
00:02:54
active mutual funds really coincides with the surge in mutual funds overall in in fact uh index funds or passive
00:03:02
funds have actually had a somewhat higher rate of growth than active mutual funds but the overall mutual fund
00:03:08
industry has grown so much uh over the decades that active funds too have become uh much bigger in the sense that
00:03:16
they control a much bigger segment of the uh US Stock Market uh we believe that uh some the
00:03:25
overall trend in mutual fund growth just coincides in general with the uh increasingly smaller fraction of the US
00:03:33
Equity Market that's owned directly by individuals uh the growth in retirement
00:03:38
plans such as uh you know defined contribution of 401K plans is is is one uh Big Driver of that growth and there
00:03:46
other institutional factors that have been identified as leading to this surge in in mutual fund uh
00:03:57
size as there more Mutual fund dollars out there uh competing with each other and looking for mispriced
00:04:06
stocks then there's more trading on those ideas that pushes prices and that's going to make it harder for any
00:04:12
mutual fund to find a mispriced stock so the analogy we like to use is that if there are more people fishing on the
00:04:19
same Pond well that's going to make it harder for any individual person to catch fish on that
00:04:28
pond well as Luke mentioned earlier in order to understand skill we have to understand what the role of scale or
00:04:34
size of of industry in the fund is in in generating performance so we Define skill as the ability of a manager to
00:04:43
perform relative to a benchmark uh abstracting from the effects of Industry size and his own fund size U so one way
00:04:52
of thinking about that is we try to ask uh how much outperformance would this manager have if he were the only only
00:04:59
one operating in the stock market and didn't have competition from all the other mutual funds and in fact didn't
00:05:06
have to worry about how big his own fund got in some sense it's his ability to
00:05:10
generate Returns on the first dollar you'd invest with that with that fund manager well we don't really know for
00:05:21
sure but uh we do know that uh certainly the education of uh those entering the financial services industry has
00:05:29
increased over time uh so the training has gone up um also uh over time new strategies get discovered uh we have uh
00:05:39
for example quantitative approaches to Investment Management that exploit technology and Computing capabilities uh
00:05:47
to much greater degrees than we could decades ago uh so we believe things like training and
00:05:53
Technology uh lead to uh higher degrees of skill as well as uh the usual ual sort of learning on the job effects uh
00:06:03
uh we believe that skill is uh increased for those reasons and possibly others we
00:06:08
don't really know why for sure we show that skill has gone up over the last 30
00:06:12
Years yet performance has not how is that possible our explanation combines two elements uh the first is the mutual
00:06:21
fund industry has been growing steadily over the last 30 years the second element is decreasing returns to scale
00:06:27
at the industry level and in other words funds are becoming more skilled but the
00:06:32
industry is also growing and those two effects tend to offset each other in other words yes fund managers are more
00:06:39
skilled today but they have to be more skilled just to uh keep up with the rest of the
00:06:47
pack so as a fund gets larger it starts to make larger trades those larger trades push prices more against the fund
00:06:56
which hurts the fund's profits yeah for examp example if you have a fund that uh
00:07:01
thinks a given stock is underpriced and wants to buy 5,000 shares of that stock uh it has to go and uh find someone
00:07:10
willing to sell that stock in the market if if another fund identifies a stock is
00:07:14
under pric and wants to buy 50,000 shares of that stock it's got to find more potential sellers of that stock to
00:07:21
do so it either has to offer a bigger concession willing to pay more for that stock to get it quickly or it has to try
00:07:28
to parcel out it's its purchases over time and take longer and perhaps thereby
00:07:34
miss out on some of the underpricing that would get corrected in the meantime I think we were surprised uh
00:07:45
because some some of the uh the leading uh theory about mutual funds these days assigns a a central role to the notion
00:07:53
that as a given fund gets bigger uh it should become become harder for it to perform um so I think we were somewhat
00:08:00
surprised that even though our estimates uh pointed in the direction we were not
00:08:04
able to get strong statistical Precision associated with those estimates uh so I
00:08:10
think that was one aspect of our study we found somewhat surprising the logic for for why a fund
00:08:17
Size Matters is compelling but there is a a different logic pointing in the other direction for example imagine two
00:08:25
mutual funds that follow exactly the same strategy they make the same trades at the same times well you can see that
00:08:33
their individual sizes may not matter instead what's going to matter is their
00:08:37
combined size well again here's one of these findings we don't have a a a definitive
00:08:46
answer for um but one one potential reason is that uh younger funds could also come with younger managers on
00:08:55
average uh so we get back to this issue of uh increases in skill and and uh sort
00:09:01
of technological prowess perhaps being associated uh with with age um the other thing is the younger funds could be
00:09:09
exploiting newer strategies that the market has not sort of sort of caught on to and exploited to as significant a
00:09:16
degree again this is one of those things like uh um Rising skill we don't we
00:09:22
can't really say for sure why it's happened but but uh we think it's not
00:09:26
implausible that uh that these factors could contribute to Superior performance for younger funds we find that there's
00:09:33
also a second way in which fund age matters and uh that's a relation over time between performance and age we find
00:09:41
that a fund's performance typically deteriorates as the fund ages uh if you take all these results together they're
00:09:49
consistent with a simple story the story is that new funds entering the industry
00:09:54
have more skill than the existing funds possibly because of better education or better grasp on technology because of
00:10:01
this Superior skill the young funds outperform initially they outperform their benchmarks and they also
00:10:07
outperformed the older funds but performance tends to deteriorate as a fund ages and the reason is that as a
00:10:15
fund ages the mutual fund industry is getting larger and larger and that hurts everyone's
00:10:23
performance investors should prefer newer active funds over older active FS funds uh each month we form a portfolio
00:10:33
uh that contains all of the youngest funds say funds that are of age between Zer and three years we also form a
00:10:39
portfolio of funds that are 10 years old and older and we find that the portfolio
00:10:44
of very young funds significantly outperforms the portfolio of of older funds well here's sort of the bad news
00:10:55
of this of this uh finding is that even though we find younger funds significantly outperform older funds in
00:11:01
the active fund Universe uh active funds in general be they young or old uh on average have
00:11:09
underperformed uh passive index funds so uh our message would be to someone who has decided to invest at least part of
00:11:19
their money in active funds uh younger funds do seem to on average offer spr performance but uh the overall averages
00:11:26
do favor index funds uh and potentially because of this finding that the uh industry Size Matters so uh
00:11:36
you know as long as the industry is as big as it is the active fund industry is as big as it is uh index funds may offer
00:11:43
a a better return uh you know were that industry to be smaller were it to shrink
00:11:48
and indeed index funds are growing more rapidly uh there could come a time when active funds uh are able to keep Pace uh
00:11:58
and perhaps even offer some prep performance but uh the evidence for now anyway would seem to be that uh index
00:12:05
funds uh uh offer offer Superior average returns based on historical evidence well we are following up
00:12:17
actually in fact we have a a uh a recent working paper that also explores the role of fund size in a somewhat
00:12:24
different way we're looking at the uh the turnover of of funds how how much they trade and to what extent that
00:12:31
turnover seems to be related to Performance do funds earn more after they after they trade more does a given
00:12:38
fund when it trades more heavily produce Superior returns as a result and uh there we do find that that fund size
00:12:45
does seem to play a role in particular small funds do seem to exhibit a stronger relation between their turnover
00:12:51
and their performance suggesting they can more readily exploit these time varying opportunities to identify Mis
00:12:58
pric see