An argument in favor of investing in actively managed mutual funds is that economies of scale accrue when large pools of money are put to work. Bigger mutual funds should be able to bargain with brokerages to drive down costs, and the same infrastructure created to manage $100 million can scale up to manage $10 billion without adding proportional costs.

But this often isn’t what happens, argues research by Chicago Booth’s Lubos Pastor, University of Pennsylvania’s Robert F. Stambaugh and Lucian A. Taylor, and University of Queensland’s Min Zhu.

Their findings are the latest salvo in a debate. Despite the economies of scale argument, a December 2004 study published in the American Economic Review, for instance, found that larger actively managed funds are more likely to underperform both the market and smaller competitors. This is counterintuitive. Assets tend to chase performance, so funds that are large must have impressed investors at some time. (The same doesn’t apply to passive funds that follow indexes.)

In a 2015 paper, Pastor, Stambaugh, and Taylor published evidence of what they call “diseconomies of scale” in the fund-management industry. University of Queensland’s Min Zhu arrived at a similar conclusion in 2018.

Into the controversy stepped University of Texas at Arlington’s John Adams, University of Georgia’s Darren Hayunga, and Virginia Tech’s Sattar Mansi, who in 2018 blasted the diseconomies of scale research as shot through with errors. They take issue with some fund classifications by Morningstar that they say created a false picture of laggard returns.

Pastor, Stambaugh, Taylor, and Zhu joined forces to publish a rebuttal. They went back to the data, refined and redid their analyses, and find that the errors their critics claim to have found are not really errors.

More than half the issues cited, for example, pertain to the $270 billion Growth Fund of America, the largest mutual fund in the country, the four researchers argue. Adams, Hayunga, and Mansi maintain that Morningstar improperly benchmarks Growth Fund of America against the growth-oriented Russell 1000 Index.

Pastor and his team disagree, but as a compromise, they dispense with index-based benchmarks altogether in favor of judging funds’ performance against the three-factor model created by Chicago Booth Nobel laureate Eugene F. Fama and Dartmouth’s Kenneth R. French. Factors are the characteristics of companies and the economy that influence stock or bond returns. Larger funds, including the Growth Fund of America, underperform against that yardstick as well, the four researchers find.

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While Adams, Hayunga, and Mansi further argue that the underperformance of outlier funds should be thrown out, Pastor and team maintain that doing so would give up valuable data. Outlier returns, they argue, should not be dismissed because they may be part of the evidence that larger managed funds underperform. Removing funds with extreme performance from the analysis would be akin to dropping stocks that have experienced sharp declines from an index, they write.

Larger funds tend to hold portfolios that hew closely to benchmarks—making them more like passive funds, but potentially with higher fees. The lack of differentiation reduces volatility against the benchmark but also robs managers of opportunities to outperform. The more a portfolio looks like its benchmark, the closer its performance will be.

If larger funds copy the benchmarks, that has implications for the performance of the entire mutual fund industry, the researchers conclude. “The same logic naturally extends from fund size to industry size, because when funds become bigger, so does their industry,” they write. “As a result, benchmark-adjusted fund returns are less volatile when industry size is larger.”

In short, big funds lead to big asset managers—and big has performance issues, the researchers demonstrate.

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