Indexing and Active Fund Management: International Evidence

Martijn Cremers

University of Notre Dame

Miguel A. Ferreira

Nova School of Business and Economics; European Corporate Governance Institute (ECGI)

Pedro P. Matos

University of Virginia – Darden School of Business; European Corporate Governance Institute (ECGI)

Laura T. Starks

University of Texas at Austin – Department of Finance

Journal of Financial Economics (JFE), Forthcoming

Abstract:

We examine the relation between indexing and active management in the mutual fund industry worldwide. Explicit indexing and closet indexing by active funds are associated with countries’ regulatory and financial market environments. We find that actively managed funds are more active and charge lower fees when they face more competitive pressure from low-cost explicitly indexed funds. A quasi-natural experiment using the exogenous variation in indexed funds generated by the passage of pension laws supports a causal interpretation of the results. Moreover, the average alpha generated by active management is higher in countries with more explicit indexing and lower in countries with more closet indexing. Overall, our evidence suggests that explicit indexing improves competition in the mutual fund industry.

Indexing and Active Fund Management: International Evidence – Introduction

Practitioners and academics have long debated the societal benefits and degree of competition in the asset management industry, particularly among equity mutual funds. This debate has focused primarily on two dimensions – the relative value of passive versus active management and the question of price competition in the mutual fund industry.1 In this paper, we contribute to this debate by examining actively and passively managed equity mutual funds in 32 countries. Elucidating this debate is particularly important because much of the recent growth in assets in the mutual fund industry has been in explicitly indexed equity funds (index funds and exchange-traded funds (ETFs)), which have grown from constituting about 14% of assets under management in 2002 to about 22% in 2010. These explicitly indexed funds have thus become a common low-cost alternative for investors to access the stock market, allowing them to buy “beta exposure” (i.e., investing in a diversified portfolio tracking a stock index) at substantially lower fees compared to active funds.

In a Grossman and Stiglitz (1980) world, one would expect passive and active funds to coexist in equilibrium with their relative market shares depending on information costs and overall market efficiency. Thus, the empirical observation of flows into explicitly indexed funds has implications for how such an equilibrium would be expected to change. In particular, Coates and Hubbard (2007) and Khorana and Servaes (2012) suggest that mutual fund markets in the United States and elsewhere are competitive, but that they have different levels of competition.2 In addition, Wahal and Wang (2011) show that the entry of new active funds that are close substitutes to incumbent funds creates competitive pressure for the incumbent funds to decrease their fees. We build on this evidence and hypothesize that increasing competition from indexed funds will lead active funds to compete via price (by lowering their fees) and/or product differentiation (by diverging more from their benchmark index). This competitive pressure could benefit fund investors directly through lower fees and indirectly through stronger incentives for skilled active managers to collect information and generate alpha.

The alternative hypothesis is that active and passive fund markets are largely segmented such that investors do not consider these fund types to be substitutes. Rather the investors may perceive active funds as differentiated investment vehicles, which then have higher fees as compensation for alpha generation or for satisfying different investor needs than what is delivered by passive funds.3 In this case increasing market shares for indexed funds may not lead to lower fees and higher differentiation by the active funds. Such an outcome would be similar to the “generics paradox” phenomenon in the pharmaceutical industry where researchers have shown that the introduction of generic drugs (which would be analogous to index funds and ETFs in our context) does not necessarily lead to the expected price drops by the branded drugs (which would be analogous to fees of active funds in our context).

indexing

See full PDF below.