Younger and actively managed mutual funds have a tendency to outperform much older, active funds, and their benchmarks, according to a study published by Wharton professors Robert Stambaugh and Luke Taylor as well as Lubos Pastor of the University of Chicago.
Active mutual funds overweight stocks that they believe underpriced and offer superior returns. The funds also sell off stocks that are overpriced or offer worse returns. In other words, active mutual funds trade more than passive mutual funds, and its return have “tracking error.”
Mutual funds’ performance decline as they age
The study entitled “Scale and Skill Active Management” indicated that while younger mutual funds beat the returns of their older competitors in the industry, their performance tend to decline as they age.
The authors of the study explained that the arrival of new competitors makes it difficult for existing mutual funds to compete in the active management industry, which is becoming bigger,
In an interview with Knowledge @Wharton, Prof. Taylor explained that they tested two different ideas in their study.
The first idea was decreasing returns to scale at the fund level— as mutual funds become larger; that causes the performance to drop. According to Prof, Taylor, “larger fund makes larger trades, the push price is more and that hurts performance.
The second idea was decreasing returns to scale at the industry level—the overall mutual fund industry gets larger—that makes all funds’ performance decrease. Prof. Taylor explained that as more mutual funds compete and look for mispriced stocks, it would be harder for any mutual fund to find a good trading opportunity because prices move.
Based on the results of their study, there was a strong evidence of decreasing returns at the industry level. They found mixed evidence of decreasing returns at the fund level.
Prof. Taylor said, “It’s the size of the mutual fund industry that’s very important for performance.”
Prof. Stambaugh noted that the increasing popularity of active mutual funds coincided with the overall growth of the industry. According to him, active mutual funds now control a much bigger segment of the U.S. stock market.
Young mutual funds have superior skill
Professor Stambaugh said they observed that the education or training in the financial services industry increased over time. He added that they discovered new strategies. He said, “We believe things like training and technology lead to higher degrees of skill as well as the usual sort of learning-on-the-job-effect.”
On the other hand, Prof. Taylor said, mutual funds are “becoming more skilled, but the industry is also growing and those two effects tend to offset each other, Yes fund managers are more skilled today, but they have to become more skilled just to keep up with the rest of the pack.”
Prof. Taylor noted that new mutual funds entering the industry had more skills than existing funds. According to him, probably because they have a better education or better understanding of technology.
He said young mutual funds outperform initially because of their superior skill. Prof. Taylor noted that the performance of the mutual funds declined as they get older because the industry is getting bigger and bigger, which hurts the performance of everyone.
Investors should prefer younger, active mutual funds
Prof. Taylor said investors should prefer younger, active mutual funds because their portfolio outperforms significantly than their older counterparts. He also noted that active funds (young or old) on average underperformed passive index funds.
“To someone who has decided to invest at least part of their money in active funds, younger funds do seem to, on average, offer superior performance. But the overall averages do favor index funds,” said Prof. Taylor.
Aging population will present “massive problem”
Separately, Stan Druckenmiller told Bloomberg that an aging population will present “massive problem” for the United States over the next 15 years. According to him, the government needs to reduce payments to the elderly. Over the past several years, he argued that the increasing costs of Social Security, Medicare and Medicaid will bankrupt the country’s youth.
Druckenmiller said, “The young people are not going to be talking about cutting back. There will be nothing to cut back.” He added, “We’re going to go from five workers of working age supporting every elderly person to two and a half because of demographics. We’re just using more and more of society’s resources to fend for the old people.”