Is the Active Fund Management Industry Concentrated Enough?

Abstract

We study the effects of market concentration levels on the active fund management industry (AFMI). We introduce a model of an AFMI equilibria in which size, performance, and effort are endogenously determined under a continuum of exogenous market concentration levels. Higher market concentration (for a given number of funds) leaves more unexplored investment opportunities and allows managers to more efficiently use industry resources, making marginal managerial effort more productive in creating alphas. However, with higher market concentration, managers can get higher compensation for their effort, causing a higher opportunity cost of effort. We find that in equilibrium, higher market concentration levels induce higher net alphas and AFMI size (the ratio of assets under active management to total wealth) if and only if gains from better investment opportunities exceed the consequences of higher managerial costs. We specialize the model to allow endogenous concentration levels and, using the Herfindahl-Hirschman and other indices, empirically study its key predictions in the United States equity AFMI in the last four decades. We find that, on average, AFMI net alphas and AFMI size increase with market concentration. Given the current low market concentration in the U.S. AFMI and with no change in managerial productivity/effort opportunity costs, an increasing market concentration is likely to increase both AFMI net alphas and size. We also look at equilibria with colluding fund managers and examine AFMI’s direct benefits.