Working Paper: NBER ID: w15646
Authors: Lubos Pastor; Robert F. Stambaugh
Abstract: We argue that active management's popularity is not puzzling despite the industry's poor track record. Our explanation features decreasing returns to scale: As the industry's size increases, every manager's ability to outperform passive benchmarks declines. The poor track record occurred before the growth of indexing modestly reduced the share of active management to its current size. At this size, better performance is expected by investors who believe in decreasing returns to scale. Such beliefs persist because persistence in industry size causes learning about returns to scale to be slow. The industry should shrink only moderately if its underperformance continues.
Keywords: No keywords provided
JEL Codes: G10; G20
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 (L25) | ability of fund managers to outperform passive benchmarks (G11) |
| size of the active management industry (L25) | expected returns (G17) |
| past performance (C52) | future allocations (G31) |
| beliefs about returns to scale (D24) | persistence of the active management industry (G23) |
| decreasing returns to scale (D24) | ability of fund managers to outperform passive benchmarks (G11) |
| investors' allocations (G11) | learning about returns to scale (E23) |