How Mutual Funds Compensate for Trading Costs

Abstract

Mutual funds potentially face diminishing returns to scale due to the fact that trading cost per dollar increases with trading size. Nonetheless, empirical analysis shows that returns of mutual funds do not depend on fund size. Two theories have been offered to explain this: According to Berk and Green large funds have more pre-trading cost skill and more trading cost, in equal measures; according to Fama and French both skill and trading costs are close to zero, and therefore independent of size. We offer an alternative theory based on the assumption that fund managers are profit maximizers and investor selection forces the expected returns of funds to be independent of size. Using a reduced model we show empirically that trading costs per dollar traded do indeed increase with size. Large mutual funds compensate for this by charging lower fees and trading more stocks less frequently. Surprisingly, pre- cost skill is nearly independent of size, and is in fact slightly smaller for large funds.