Scale and Skill in Active Management

We empirically analyze the nature of returns to scale in active mutual fund management. We find strong evidence of decreasing returns at the industry level: As the size of the active mutual fund industry increases, a fund’s ability to outperform passive benchmarks typically declines. In contrast, estimates that avoid econometric biases do not find decreasing returns at the fund level. We also find that funds born more recently exhibit more skill. This upward trend in skill coincides with industry growth, which precludes the skill improvement from boosting average fund performance. Finally, we find that a fund’s performance typically declines over its lifetime. This striking result can also be explained by industry growth and industry-level decreasing returns to scale