In a recent academic paper written by Lubos Pastor (Booth School of Business) Robert F. Stambaugh (The Wharton School) and  Lucian A. Taylor (The Wharton School), the size of actively managed mutual funds, the size of the actively managed mutual fund industry, and the skill of active mutual fund managers were studied to determine how they affect the performance of actively managed funds.

The study found that the size of an actively managed fund does not have a significant correlation with performance, but the size of the actively managed fund industry does have a significant, and negative correlation with fund performance. The data showed  that a 1% increase in the size of the actively managed fund industry comes with an almost 40bp decrease in the annual performance of the sample of funds examined. The data seems to show that as the size of the actively managed fund industry grows, markets become more efficient.

One of the most interesting parts of this study as it relates to efficient markets is that the returns attributable to fund manager skill have actually increased over the period 1979-2011. The authors consider that the increase in measured skill could be attributed to manager experience, education, or the better use of technology, but it hasn’t been evident in returns because of the negative correlation between industry size and actively managed fund performance.

This paper confirms that competition drives the efficiency of markets; as more entrants compete for alpha, it becomes more difficult to generate. Knowing that it gets harder and harder to beat the market as more people invest in beating the market, and keeping in mind that the cost of an actively managed dollar generally exceeds the cost of a passively managed dollar, the question of why people continue to invest in active mandates is difficult to answer.