Decreasing Returns to Scale, Fund Flows, and Performance
59 Pages Posted: 22 Jun 2017 Last revised: 6 Jul 2017
Date Written: June 26, 2017
Theoretical models imply fund size and performance should be negatively linked. However, empiricists have failed to uncover consistent support for this negative relation. Using a new econometric framework which includes fund-specific sensitivities to decreasing returns to scale, we find a both economically and statistically significant negative relation between fund size and performance. Exploiting fund heterogeneity to decreasing returns to scale, we show that investors direct flows to those funds with low sensitivity to decreasing returns to scale. Interestingly, investors appear to over-allocate capital to these low sensitivity funds leading to significantly negative excess performance.
Keywords: Performance Evaluation, Mutual Funds, Hedge Funds, EM Algorithm, Fixed Effects, Random Effects, Scale, AUM, Alpha
JEL Classification: G10, G11, G12, G14, G23, G24
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