When Fund Flows Take the Fun (Alpha) Away

Abstract

We design a new test for diseconomies of scale at the mutual fund level, and document that quarterly changes in fund performance are negatively related to lagged predicted fund flows. The effect is economically and statistically significant for both inflows and outflows. Results hold for factor alphas and benchmark adjusted returns, and are robust to econometric biases. The flow-performance mechanism is strongest for more active funds with higher expense ratios and for funds trading smaller and more illiquid stocks. Consistent with the Berk and Green (2004) model, we find that alphas would be more cross-sectionally dispersed and more persistent without the damping effects of flows.

Keywords: diseconomies of scale, mutual funds

JEL Classification: G23