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Not All Success is the Same: The Role of Exploration and Exploitation in Diseconomies of Scale in the Mutual Fund Industry

44 Pages Posted: 12 Sep 2012 Last revised: 2 Jul 2013

Huijun Wang

University of Delaware

Date Written: September 11, 2012

Abstract

This paper investigates the role of diseconomies of scale in mutual fund performance. I argue that there are two crucial aspects that are related to subsequent performance. In addition to the well-known metrics based on past returns (i.e., $\alpha$ and tracking errors), I demonstrate that managerial ability to overcome diseconomies of scale is also a key factor. I propose two new proxies for the degree of diseconomies of scale by contrasting two types of past success, namely, accumulated success in industry exploration (i.e., buying stocks from unknown industries) and accumulated success in industry exploitation (i.e., buying stocks from familiar industries). Accumulated success in industry exploration, representing low degree of diseconomies of scale, plays a significant positive role in absorbing fund inflows, leading to good and persistent benchmark-adjusted performance in the subsequent period. By sharp contrast, accumulated success in industry exploitation, representing high degree of diseconomies of scale, does exactly the opposite. Although these results suggest the importance of different degrees of diseconomies of scale in fund performance, I find that only investors in good performing funds realize their distinction.

Keywords: Mutual fund performance, diseconomies of scale, exploration, exploitation

JEL Classification: G21, G23

Suggested Citation

Wang, Huijun, Not All Success is the Same: The Role of Exploration and Exploitation in Diseconomies of Scale in the Mutual Fund Industry (September 11, 2012). Available at SSRN: https://ssrn.com/abstract=2144973 or http://dx.doi.org/10.2139/ssrn.2144973

Huijun Wang (Contact Author)

University of Delaware ( email )

B & E Finance, UD
306 Purnell Hall
NEWARK, DE Delaware 19716
United States

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