Bigger is Not Always Better: An Examination of Decreasing Returns to Scale in Mutual Fund Performance

Abstract

Mutual funds manage tens of trillions of dollars and aim to find investment opportunities that will maximize returns with minimal risks. This paper aims to contribute to the literature understanding mutual fund performance by examining the relationship between fund size and fund performance. A cross sectional model is used to investigate this relationship for actively managed funds from 1962 to 1999 and from 2010 to 2020. The models yield a significant inverse relation between fund size and fund performance for both periods that is stronger among funds with a small cap investment style, supporting the idea that liquidity plays a role in fund size eroding performance. However, fund family size had a positive effect on fund performance, indicating size may not necessarily be bad for performance. This result points to potential organizational diseconomies within the industry. This paper also examines the historical value at risk and conditional value at risk for portfolio quintiles sorted by fund size to find that smaller funds have a more positively skewed distribution of returns. However, smaller fund returns also seem to have a wider distribution, leading to more value at risk compared to larger funds. Separate analysis for pure index funds during 2010 to 2020 also yields a significant inverse relation between size and performance, indicating reasons pertaining to active management may not be the only drivers of this phenomenon. Overall, this paper finds a statistically and economically significant inverse relationship between fund size and fund performance that is consistent across time and samples. This paper also adds more data on the role of liquidity, fund style, active management, and the distribution of fund returns in mediating this relationship.