By analyzing the nature of returns in the mutual fund industry, the authors find strong evidence of diminishing returns to scale on an industry level. The evidence is mixed at the level of individual fund performance, despite the finding that skill levels in the active management industry have increased over time.
What’s Inside?
The authors conduct empirical research to find evidence of decreasing returns to scale in active mutual fund management at both the fund and industry levels. Although they are unable to establish statistical significance for their findings of decreasing returns to scale on a fund level (i.e., a declining ability of a fund to outperform as its size increases), they find strong evidence at the industry level, especially for funds with high turnover and volatility as well as for small-cap funds, despite evidence of improvement in fund managers’ skill levels. The authors also find that newer funds tend to outperform the market as well as their older counterparts and have higher skill levels. But their performance still declines over time as the industry expands and grows increasingly competitive.
How Is This Research Useful to Practitioners?
The authors demonstrate that the average skill level in the industry is improving and that new funds tend to perform better than their mature counterparts. These findings seem to indicate that new managers probably possess higher skill levels, have greater access to or capabilities with technology, and are, perhaps, more highly motivated. Older managers of established mutual funds should analyze their performance vis-à-vis their new counterparts to determine the nature of any shortfall.
How Did the Authors Conduct This Research?
The authors test two hypotheses: fund-level decreasing returns to scale and industry-level decreasing returns to scale. At the fund level, they find only mixed evidence of decreasing returns to scale, whereas at the industry level, they find consistent evidence.
The dataset spans 1979–2011 and covers 3,126 actively managed US equity mutual funds. Only those equity funds that appear in both the CRSP and Morningstar databases are selected so that the accuracy of their data can be verified. Morningstar facilitates fund classification by assigning each fund a category, designates a benchmark portfolio for each category, and also provides benchmark returns.
The research uses a fund’s gross monthly benchmark-adjusted return to measure fund performance against the benchmark portfolio assigned by Morningstar. Gross return, fund size, and industry size are the main variables used in the regression analysis. Ordinary least-squares (OLS) regressions are estimated both with and without fund fixed effects. To avoid biases in the OLS regressions, moreover, the authors apply a recursive demeaning procedure to validate their findings.
Abstractor’s Viewpoint
The authors have pointed out areas for future research arising from the conclusions of their findings. These include determining the source of increasing skill levels in the mutual fund industry, what is behind the negative relationship between industry size and fund performance, and whether the trends in the US market discovered by their research also exist in international markets.