Decreasing Returns to Scale, Fund Flows, and Performance

Abstract

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 structurally models 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.

First posted to SSRN: June 22, 2017

Keywords: Performance Evaluation, Mutual Funds, Hedge Funds, EM Algorithm, Fixed Effects, Random Effects, Scale, AUM, Alpha

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