Working Paper: CEPR ID: DP7637
Authors: Lubo Pstor; Robert F. Stambaugh
Abstract: We analyze the equilibrium size of the active management industry and the role of historical data---how investors use it to decide how much to invest in the industry, and how researchers use it to judge whether the industry's size is reasonable. As the industry's size increases, every manager's ability to outperform passive benchmarks declines, to an unknown degree. We find that researchers need not be puzzled by the industry's substantial size despite the industry's negative track record. We also find investors face endogeneity that limits their learning about returns to scale and allows prolonged departures of the industry's size from its optimal level.
Keywords: active management; learning; returns to scale
JEL Codes: G11; G12; G20; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Size of the active management industry (S) (L25) | Ability of fund managers to outperform passive benchmarks (α) (G11) |
| Ability of fund managers to outperform passive benchmarks (α) (G11) | Average returns for investors (G11) |
| Size of the active management industry (S) (L25) | Average returns for investors (G11) |
| Investors' learning about decreasing returns (G11) | Allocations to active management (G11) |
| Allocations to active management (G11) | Size of the active management industry (S) (L25) |