Another Study Favors Passive Investing

Did you know that the first index fund wasn’t launched until 1971? Although actively managed funds had almost a 50 year head start, index funds (i.e., passive investing) have been gaining ground in recent years, largely because their fees are lower and the great percentage of active managers fail to beat their benchmark. In fact, in the 10 years ending in 2013, the market share of indexed stock investments has grown from 17% to 35%, according to Morningstar. Also, many active managers failed to offer protection and outperform in the most recent downturn.

New research by two Wharton professors and a colleague at the University of Chicago explores another hurdle active funds have to overcome (in addition to increased costs due to more research and more trading): the growing size of the mutual fund industry. That is, “Scale and Skill in Active Management” posits that the more active funds there are in an asset class, the more difficult it is for any individual fund to beat its benchmark.

That’s common sense. If your child attends a school with 2,000 students it will be more difficult to make the starting five on a basketball team than if he attended a school with just 1,000 students. The same holds for the fund industry. Just as active managers have more talent to compete against today, stocks receive increased analysis.

The researchers did, however, find that manager skill increases over time. For example, they found that average returns on the first dollar invested grew from 24 basis points per month in 1979 to 42 in 2011. And although they found younger ones tend to perform better than older ones, they lose that edge over time to, you guessed it, the fund industry’s growth!

Wharton’s Professor Stambaugh summed up the research by noting, “Competition matters. In recent decades, growing skill among active-fund managers has helped to offset the damaging effects of industry growth. However, if skill were to stop rising, then any continued increase in the size of the industry would probably hurt performance going forward.”

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