Returns to scale link industry size and performance
Research involving the University of Chicago Booth School of Business and the Wharton School, University of Pennsylvania, points to a potential answer to the question of why the active management industry is able to maintain assets despite poor performance.
The research authors Ľuboš Pástor, professor of Finance at Booth and Robert Stambaugh, professor of Finance at Wharton, suggest that the answer lies in how investors react to economies of scale.
“Using a model with competing investors and fund managers, we find that the large observed size of the active management industry can be rationalized if investors believe that active managers face decreasing returns to scale. If investors instead believed that returns to scale were constant, they would allocate nothing to active management today, even if they were initially more optimistic about active managers’ abilities,” the authors conclude.
“Under decreasing returns to scale, investors adjust their allocation in response to performance to achieve the desired expected return going forward. After a period of underperformance, the proportional allocation to active management should be smaller than it was at the beginning of the period, but it should also remain substantial.”
To read the full research click here: On the size of the active management industry