Investment universe-level returns to scale and active fund management

Abstract

Research shows that competition negatively impacts fund alpha. I derive that fund managers can counteract this impact by adjusting the level of active management. In an international sample, I find that the impact of competition in funds' investment universe depends on its source: funds face decreasing returns to the total size of active funds and increasing returns to the total size of passive funds. This implies that managers should increase active management when passive fund competition rises and reduce it when active fund competition increases. Empirical evidence suggests that managers adjust only to changes in competition from passive funds.

Keywords: Mutual funds, Active fund management, Competition, Decreasing returns to scale, Equilibrium

JEL Classification: G11, G20, G23