Does Scale Impact Skill?

Abstract

Borrowing insights from the literature on cross-country economic growth, we study the impact of scale on fund performance within a new econometric framework that features fund fixed effects, fund-specific impact of scale, and a simultaneous estimation of the impact of scale and exposures to benchmark risk factors. Applying our method to mutual fund data, we find an economically and statistically significant impact of individual fund scale. For an average fund in the cross-section, we estimate a drop in alpha of 20 basis points if the fund doubles its size over one year. We also find a non-negligible impact of the size of the fund industry, although its magnitude is significantly smaller than the impact of individual fund scale. We reconcile our findings with existing empirical studies. Taken as a whole, our results lend considerable support to theoretical models that build on the premise of decreasing return to scale for active portfolio management.

Keywords: Performance evaluation, Mutual funds, Hedge funds, EM algorithm, Fixed effects, Random effects, Scale, AUM, Alpha

JEL Classification: G10, G11, G12, G14, G23, G24