Trade Less and Exit Overcrowded Markets: Lessons from International Mutual Funds
Teodor Dyakov, Hao Jiang, Marno Verbeek
Review of Finance, Volume 24, Issue 3, May 2020, Pages 677–731, https://doi.org/10.1093/rof/rfz014
We study active investment skills in relation to returns to scale in the active mutual fund industry. Our sample comprises 13,807 funds from 16 domicile countries investing in 42 equity markets from 2001 to 2014. We find that, in the aggregate, mutual funds tend to lose money on their trading, even before costs: the stocks they buy underperform those they sell by 18 basis points (bps) per month in the subsequent quarter. Although the negative trading performance comes from both U.S. and internationally domiciled funds, it tends to concentrate in the U.S. equities they trade. For instance, U.S. domiciled funds achieve an average negative return of 34 bps per month to their trades in U.S. equities, whereas their trades largely break even in the international equity markets. A similar pattern holds for internationally domiciled funds. This initial result suggests that the U.S. equity market may be more crowded with active funds, which constrains their trading performance.
To formally examine the impact of the scale of active funds on their performance, we test for the presence of decreasing returns to scale in the U.S. and international equity markets. At the industry level, we find strong evidence of decreasing returns to scale in active fund management when they invest in U.S. equities. A 1% expansion of active funds relative to the U.S. equity market value associates with a decline of 14 bps per month in returns to their equity trades, and a decline of 7 bps per month in returns to their equity holdings. These results clearly illustrate the adverse impact of crowded active investing at the industry level on individual funds’ performance.
Grouping international mutual funds together, we find that an increase in active fund industry size has a negative impact on their trading performance. The magnitudes are comparable to those for the U.S. funds. Looking at each region individually, we are able to find reliable evidence of decreasing returns to scale for funds investing in Asia-Pacific, Europe, and Emerging Markets. Our data do not enable us to find statistically significant evidence of decreasing returns to scale for Canada and Japan, although the point estimates have the correct sign.
These findings naturally raise the question: What is the optimal size of the active mutual fund industry in these markets? Extending Berk and Green (2004) and Berk and van Binsbergen (2017), we develop a simple statistical distribution theory for the optimal industry size. Our results indicate that the size of active fund industry has exceeded the optimal level at the 95% confidence level in U.S. at the end of our sample period. For international markets, however, the actual size lies within the 95% confidence interval across the five regions. The point estimates for efficient industry size show that for Asia-Pacific and Emerging Markets, there is still substantial room for further expansion of the active fund industry. Consistent with this view, we find that mutual fund managers have been gradually reallocating their assets away from the U.S. and more into international equity markets.