Why the Active Management Industry Grew: Learning about Heterogeneity in Skills

We argue that active management’s growth is not puzzling despite the industry’s poor track record. Our explanation features learning about heterogeneity in skills and decreasing returns to scale at both the fund level and the aggregate level. Investors are uncertain about parameters governing fund returns, and they learn about them from realized returns. After observing a fund’s negative performance, investors infer that the fund manager’s skill is lower than expected rather than that the aggregate-level decreasing returns to scale is higher than expected. Optimism about the industry as a whole comes at the expense of disappointment about existing individual funds. But this disappointment is signi…cantly muted away by the sustained entry of new funds. If this force is strong enough, investors increase their allocation to active management. On the other hand, fund-level decreasing returns to scale will imply that the average unit cost associated with investing in active management is lower as the number of funds increases and, ceteris paribus, make the industry grow even bigger. Quantitatively, our story can keep the whole fund industry growing even if its performance is unimpressive and can reproduce salient features of the time series of industry size. It can also rationalize the empirical fact that this industry growth coincides with net fund entry over time. Email: [email protected]. I am deeply indebted to Chris Sims, Wei Xiong, and Motohiro Yogo for their guidance and advice. I am also grateful to Markus Brunnermeier, Maryam Farboodi, Valentin Haddad, Harrison Hong, Jakub Kastl, Atif Mian, Stephen Morris, Olivier Darmouni, Ji Huang, Felix Matthys, Terry Moon, Michael Sockin, and all seminar participants at Princeton University for useful suggestions and comments.