The Empirical Law of Active Management: Perspectives on the Declining Skill of U.S. Fund Managers

Abstract

Sénéchal proposes a new analytical framework—the empirical law of active management—to assess the breadth, or diversification, and the skill of a portfolio manager. The framework requires no assumptions regarding a manager’s asset return expectations or investment process. The framework generalizes the fundamental law of active management introduced by Grinold in 1989 and creates an analytical framework for measuring skill and diversification in a consistent manner for large cross sections of funds. The author applies this framework to analyze the evolution of skill and of diversification since 1980 for 2,798 U.S. mutual funds. He finds that skill has been declining among U.S. mutual funds while diversification has been increasing. The author suggests two explanations for the observed decrease in skill. First, the growth in mutual fund assets has made it more difficult for the industry as a whole to outperform the market. Second, based on the author’s analysis of the relationship between skill and diversification, he concludes that the U.S. mutual fund industry responded to an increase in the demand for its products by creating funds with low information content.