Is The Active Fund Management Industry Concentrated Enough?
Banking and Finance, UNSW Business School, UNSW Australia; Financial Research Network (FIRN)
University of New South Wales
February 17, 2016
We study the effects of market concentration levels on the social efficiency of the active fund management industry (AFMI). We introduce a model of AFMI equilibria, in which size, performance, and effort are endogenously determined under a continuum of exogenous market concentration levels. Higher market concentration (for a given number of funds) leaves more unexplored investment opportunities and allows managers to more efficiently use industry resources, making marginal managerial effort more productive in creating alphas. However, with higher market concentration, managers can get higher compensation for their effort, causing a higher opportunity cost of effort. We find that in equilibrium, higher market concentration levels induce higher net alphas and AFMI size (the ratio of assets under active management to total wealth) if and only if gains from better investment opportunities exceed the consequences of higher managerial costs. We empirically study our model’s key predictions in the United States equity AFMI in the last four decades and find that, on average, AFMI net alphas and AFMI size increase with market concentration. Given the current low market concentration in the U.S. AFMI and with no change in managerial productivity/effort opportunity cost, an increasing market concentration is likely to increase both AFMI net alphas and size, and thus increase social benefits. We also look at equilibria with colluding fund managers and with endogenous market concentration levels.
Is The Active Fund Management Industry Concentrated Enough? – Introduction
Two central underpinnings of free market economics are 1) competition leads to better outcomes and 2) agents earn economic rents if and only if they have a competitive advantage. Because the incentives of earning future economic rents are crucial in motivating people to act and because people need an environment where a competitive advantage can be created so they can earn future economic rents, it is natural to try to understand whether the level of competition (or concentration1) in a given industry is optimal. This question is at the core of a central financial economic issue: the efficiency of the active fund management industry (AFMI) equilibrium. Extensive literature on the AFMI has focused on trying to understand the economic forces that can explain fund manager compensation, their ability to generate value, and the exponential growth of an industry where identifying economic value added seems elusive. See, for example, Jensen (1968), Daniel, Grinblatt, Titman and Wermers (1997), Wermers (2000), Berk and Green (2004), Pastor and Stambaugh (2012), and Berk and Binsbergen (2015).
We introduce a model of AFMI competition, effort, size, and performance, and provide a novel perspective of the U.S. active equity mutual AFMI. Specifically, we note that competition among asset management firms has grown dramatically over the past few decades with advancements in financial products and technology (see, for example, Gruber (1996) and Philippon and Reshef, (2012)). Worldwide, vast numbers of active fund managers are estimating the value of assets each day. These highly trained experts act to exploit any perceived differential—however small—between price and estimated asset value, hoping to be compensated for their efforts. This phenomenon raises important questions. Clearly, one needs some active management to ensure that security prices properly reflect relevant information, but do market concentration levels in the AFMI optimally balance opportunities and costs of alpha production? Our model provides economic insights regarding two opposing forces that influence economic outcomes when the concentration level of AFMI changes: available alpha-production opportunities and the corresponding effort costs.
Consistent with the Herfindahl-Hirschman index (HHI), we define market concentration to measure the relative size distribution in an industry with a given number of funds. Two hypotheses about the effects of market concentration prevail in the banking literature: the efficient-structure hypothesis, which suggests a positive relation between market concentration and firm efficiency, and the structure-conduct-performance hypothesis, which asserts a positive relation between market concentration and firms’ performance due to extractions of monopolistic rents. We note that these two hypotheses are not necessarily mutually exclusive. Following these hypotheses, we expect higher market concentration to
- leave more unexplored investment opportunities5 and allow fund managers to more efficiently use industry resources, such as human capital, inducing higher marginal effort efficiency; and
- facilitate fund managers to require more compensation for effort, making the opportunity cost of effort higher.
Our model allows incorporating these effects of market concentration, calibrating parameters with real-world data, and ascertaining which implications are consistent with market equilibrium.
Pastor and Stambaugh (2012), (PS), studied a framework with decreasing returns to scale (i.e., decreasing active managers’ marginal ability to outperform passive benchmarks), where interactions between active fund managers and investors determine expected alphas, net of management fees. Within their world, we model a continuum of market concentration levels and require active fund managers to exert (optimal) costly effort when competing over investment funds by producing alphas. We study equilibria with four types of investors: a single risk-neutral investor, infinitely many risk-neutral investors, a single risk-averse investor, and infinitely many risk-averse investors.
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