Decomposing Fund Activeness

Abstract

We decompose the variance of mutual funds’ active returns into its idiosyncratic and systematic components, and introduce idiosyncratic activeness (IDA) as a novel measure of the source of fund activeness. We uncover that the positive association between level of activeness and fund performance is entirely driven by high-IDA funds. We find that these funds outperform despite high-IDA strategies having more severe decreasing returns to scale, and not being inherently more profitable, suggesting that high-IDA funds are more skilled. Our decomposition also provides new insights in the evolution of smart-beta strategies in the mutual fund industry.

Keywords: mutual funds, fund activeness, idiosyncratic activeness, fund performance, managerial skill, decreasing returns to scale, smart-beta

JEL Classification: G23, G11