There is a rational models on how these results can be achieved through the normal competitive market process. There is no needs to rely on poor management skill or behavioral biases as some have suggested.A competitive model can be used to explain similar behavior with hedge funds. This competitive model can be used to help frame how investors should choose managers.
In world where it is hard to determine skill, looking at performance is useful. Money will flow to the better managers, but in a competitive markets, these money flows will continue until returns are driven down to the industry average or benchmark returns. It make sense for managers to continue to take money in even while returns are dissipated just as it makes sense for investors to give money to the better managers until returns are driven down to the market return. Excess returns may exist but may not have persistence because the money flows will drive returns back to the industry average. A competitive market where excess returns are driven out through the normal process of supply and demand can answer a lot of money management questions.
Think about the key issues:
- Small managers do better - flows or size have not forced profits lower.
- Larger firms show less profits - flows have driven returns to the average; however, the past track record keeps money in the fund.
- Alpha is reduced over time - the competitive flows drive the alpha lower.