With the passage in 2002 of the Sarbanes-Oxley Act, which greatly increased the cost of being a public company, companies are waiting to become much larger before going public.

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The result is that by 2020 the number of U.S. publicly listed stocks had fallen 50% over the prior 20 years, to about 3,500. With the number of publicly traded companies in the U.S. market decreasing, there could be an increasing  propensity for funds to crowd into the same stocks. And crowding in the same investment opportunities reduces excess profitability. In addition, as successful funds grow larger, they face decreasing economies to scale due to the market impact of their trades. That could lead to increased demand for the most liquid stocks. An interesting question is: What impact does crowding have on the performance of actively managed funds?

To answer that question, Tanja Gonzalez, Teodor Dyakov, Justus Inhoffen, and Evert Wipplinger, authors of the study “Crowding of International Mutual Funds,” published in the June 2024 issue of the Journal of Banking & Finance, analyzed the relationship between crowding and performance in the active mutual fund industry. They inferred crowding by comparing the portfolio holdings of funds on a stock-by-stock basis—computing crowding as the sum of portfolio holdings overlap across all funds with which it shares common equity positions. Their data sample is based on quarterly positions of international mutual funds from Factset and stock level information from Datastream and Worldscope between 2001 and 2014. In addition, they collected data on fund net returns (in USD) and total net assets from Morningstar Direct. The data covers both alive and defunct funds. They benchmarked performance against 13 of Vanguard’s index funds. Using the equity holdings overlap of 17,364 global funds, they found:

• Crowding (which is different than herding as it captures similarity in the level of holdings, while herding captures similarity in the changes of holdings) not only results in diminishing performance relative to passive index funds, but also leads to significant underperformance.
• Relative to traded index funds, funds in the top decile of crowding underperform passive benchmark funds by a statistically significant (t-stat= -4.5) and economically significant 1.4% per annum.  
• The difference in risk-adjusted performance between the least and most crowded decile of funds was −0.21% per month (t=−2.8) in an augmented Fama–French factor model (size, value, momentum, monthly volatility over the past 12 months, dividend yield, Ahimud illiquidity, and the number of analysts following the stock in the IBES data base).
• The demand for liquid stocks was monotonically increasing in crowding.
• The liquidity factor of Pastor and Stambaugh explained about a quarter of the spread in performance between funds in the top and bottom decile of crowding—providing for the performance effect of crowding being related to a liquidity premium (the discount for holding liquid stocks).
• Less crowded funds are earning more liquidity premia on their portfolios.
• Crowding contains novel information about performance that is not reflected in other variables that describe funds’ investment environment, such as fund size and style.
• Their results are not explained by differences in exposure to the net effect of common systematic factors (size, book-to-market, momentum, and liquidity). 
• Crowding is not limited to the North-American market, extending to European and Global markets.

The authors concluded:

“Our findings suggest that crowding of investment opportunities is important for understanding diminishing returns…. Too much similarity in investment positions of active funds is associated with performance decreases below the performance benchmark of passive funds.” 

They added:

“The loss in performance could be the price that investors with preference for liquid assets pay in order to have high degree of liquidity in their portfolios. Our findings also prompt questions about the tradeoffs managers face between liquidity and crowding.”

Investor Takeaways

The empirical research has documented that successful active management sows the seeds of its own destruction—as actively managed funds grow larger, their performance is likely to deteriorate due to diseconomies of scale as the negative price impact of their trading increases. In addition, as they grow larger, they are likely to hold more stocks, and thus have higher portfolio holdings overlap with other funds (their higher expenses must be carried by the smaller differentiated portion of the portfolio). These diseconomies are likely to lead to negative performance. The evidence presented by Gonzalez, Dyakov, Inhoffen, and Wipplinger adds to our understanding of lack of persistence in performance of actively managed funds. 

In our book, The Incredible Shrinking Alpha, Andrew Berkin and I provided evidence supporting the view that there were four trends that were increasing the hurdles to successful active management—by 2010 only about 2% of actively managed funds were generating statistically significant outperformance (alpha):

• Academic research has been converting what was once alpha into beta.
• The pool of victims that can be exploited has been shrinking.
• The competition has been getting tougher.
• The supply of dollars chasing alpha has increased.  

The shrinking pool of public companies across which active funds can diversify their holdings, increases the risk of crowding, which the research we reviewed shows negatively impacts performance. That provides yet another reason for investors to choose to avoid playing the loser’s game of active management.

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