Essays on concentration, size, performance, and benefits of the active fund management industry

Abstract

We introduce a model of the active fund management industry (AFMI), and study the effect of a continuum of exogenous market concentration levels on the AFMI’s performance (net alphas), AFMI size, and AFMI direct benefits (differences between performance benefits and costs of efforts exerted to produce them). Risk-neutral managers compete for many risk-averse investors’ investments by optimally choosing costly effort and fees to deliver net alphas. Our model predicts that AFMI performance, size, and direct benefits increase (decrease) with market concentration if and only if gains from better investment opportunities due to higher concentration exceed (fall behind) the consequences of higher managerial costs. We then model endogenous concentration levels to fit empirical concentration measures. We empirically study the U.S. equity AFMI and find that, on average, AFMI net alphas and size increase with market concentration. Under current U.S. equity AFMI’s low market concentration, and with no change in managerial productivity/effort opportunity costs, increasing market concentration is likely to increase the AFMI’s net alphas, size, and direct benefits. We extend our model to global settings. Higher foreign market concentration, implying more unexplored investment opportunities, makes managerial effort more productive, attracting efforts. Consequently, unexplored investment opportunities in local markets rise, increasing local effort productivity. However, higher foreign market concentration allows foreign managers to demand higher compensation, driving up local managers’ reservation salaries, thus, effort costs. In equilibrium, higher foreign market concentration levels induce higher local net alphas, AFMI size, and the sum of direct benefits of managerial efforts spent in local and foreign markets if and only if gains from higher gross alpha production exceed consequences of higher managerial costs. Again, to fit data, we specialize our international model to an endogenous concentration framework and empirically study the effect of U.S. equity AFMI concentration on 30 global equity AFMIs. We find that 17 (5) markets’ AFMI net alphas and 9 (2) markets’ AFMI size, on average, are significantly negatively (positively) associated with U.S. equity AFMI concentration. Under no change in managerial productivity/effort costs, the current low, and probably decreasing, U.S. equity AFMI concentration would benefit a large proportion of global equity AFMIs.