How Much Does Size Erode Mutual Fund Performance? A Regression Discontinuity Approach
The two main stylized facts in the mutual fund literature are that funds exhibit little ability to persistently outperform their peers, but new money flows into funds with the highest past returns. The traditional interpretations of these facts are that fund managers are unskilled and fund investors are unsophisticated. Berk and Green (2004) use a model that combines skilled managers with diseconomies of scale in asset management to challenge these interpretations. They argue that more-skilled managers will manage more assets but – precisely because they manage more assets – will generate the same expected future returns as less-skilled managers. In their model, standard cross-sectional regressions of fund returns on fund size will significantly underestimate diseconomies of scale. To identify the causal impact of mutual fund flows on performance, we exploit the fact that small differences in mutual fund returns can cause discrete changes in Morningstar ratings and, thereby, cause discrete differences in mutual fund flows. The diseconomies of scale that we estimate using this regression discontinuity approach are larger than those estimated in standard regressions, but generally smaller than assumed in Berk and Green – or than are required to explain the low observed levels of performance persistence.
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