Not All Success is the Same: The Role of Exploration and Exploitation in Diseconomies of Scale in the Mutual Fund Industry
University of Delaware
September 11, 2012
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.
Number of Pages in PDF File: 44
Keywords: Mutual fund performance, diseconomies of scale, exploration, exploitation
JEL Classification: G21, G23
Date posted: September 12, 2012 ; Last revised: July 2, 2013