Does Fund Size Erode Performance? Liquidity, Organizational Diseconomies and Active Money Management Joseph Chen University of Southern California Harrison Hong Stanford University and Princeton University Ming Huang Stanford University Jeffrey D. Kubik Syracuse University First Draft: April 2002 This Draft: September 2002 Abstract: We investigate the effect of fund size on performance among active mutual funds. We first document that fund returns, both before and after management fees, decline with fund size, even after adjusting performance by various benchmarks and controlling for other fund characteristics such as turnover and age. We then explore a number of potential explanations for this relationship. We find that the effect of fund size on fund returns is most pronounced among funds that play small cap stocks. Interestingly, performance only depends on fund size and does not decline with family size. Finally, small funds are better than large ones at investing in local companies. We argue that these findings are consistent with both liquidity and organizational diseconomies being important factors behind the documented diseconomies of scale in money management. __________________ We are indebted to Jeremy Stein for his many insightful comments. We are also grateful to Paul Pfleiderer, Jack MacDonald, Jonathan Reuter, Jiang Wang, Haicheng Li, Lu Zheng and seminar participants at MIT, Michigan, Illinois, and Stanford for their helpful comments. Hong also thanks the University of Michigan for their hospitality during his visit when the paper was written. Please address inquiries to Harrison Hong at [email protected] this paper, we investigate the effect of fund size on performance among active mutual funds. This issue is an important one for the mutual fund industry, which is becoming an increasingly important part of the financial markets. A better understanding of the economies of scale in this industry would naturally be useful for investors in determining which funds to hold. At the same time, it may help practitioners to optimize on a variety of decisions such as when to close funds and what compensation to give to managers. For instance, some observers worry that managerial compensation in this industry, which is typically a fixed percentage of assets under management, may have adverse side-effects in the presence of diseconomies of scale (see, e.g., Becker and Vaughn (2001)). One such adverse side-effect is that managers have a strong incentive to grow fund size at the expense of achieving higher returns for their investors. Therefore, understanding the economies of scale for mutual funds is an important first step towards addressing such critical issues. While the effect of fund size on performance is obviously an important question for the mutual fund industry and its investors, it has received little research attention to date. Indeed, there appears to be disparate views among practitioners on this issue. Some point out that there are advantages to fund size such as more resources for research and lower expense ratios (see, e.g., Fredman and Wiles (1998)). Others believe that a large asset base erodes fund performance because of trading costs associated with liquidity (see, e.g., Lowenstein (1997)). A small fund can easily put all of its money in its best ideas, but a lack of liquidity forces a large fund to have to invest in its not-so-good ideas. Big funds may also have to take larger positions per stock than is optimal, which makes it more difficult for them to get in and out of stocks than small funds.2The little research that has been done is somewhat mixed. A number of studies have documented that fund managers do have the ability to beat the market before management fees (Grinblatt and Titman (1989), Grinblatt, Titman and Wermers (1995), Daniel, Grinblatt, Titman and Wermers (1997)). Moreover, mutual fund investors are apparently naïve in that they pay too much in fees, which results in their risk-adjusted fund returns being significantly negative (Jensen (1968), Malkiel (1995), Gruber (1996)).1 To the extent that there are diseconomies of scale, we expect fund size to be inversely related to gross fund returns (before management fees are deducted). Since investors may not be sophisticated enough to avoid large funds, we also expect this inverse relationship to hold for net fund returns (after such fees are deducted).2 However, there is little direct evidence to date that fund size erodes performance. Using a small sample from 1974-1984, Grinblatt and Titman (1989) find some evidence that gross fund returns (constructed only from fund stock holdings) decline with fund size, but do not find a similar effect using net fund returns.3 Other studies use simulations to show that the asset base can significantly erode performance by assuming that bigger funds have to take larger positions in the same set of stocks and hence suffer more from price impact (see, e.g., Perold and Solomon (1991)). Needless to say, there is no consensus on this issue. Using mutual fund data from 1962-1999, we first use cross-sectional variation to see whether future performance depends on current fund size. We find that fund 1 A related literature finds that mutual fund investors are susceptible to marketing (see, e.g., Gruber (1996), Sirri and Tufano (1998) and Zheng (1999)). 2 See discussion in Gruber (1996) and Berk and Green (2002) for related analysis on the effects of diseconomies of scale and fund flows for persistence in fund performance. 3 Morningstar often release research reports that find that fund size indeed erodes performance, even measured on a net fund return basis (for these reports, see Morningstar.com). These reports also offer investors tips on which small mutual funds to buy.3performance is negatively correlated with total net assets, where performance is measured with both gross and net fund returns. For instance, using CAPM-adjusted, four-quarter gross returns, funds in the smallest fund size quintile outperform funds in the largest fund size quintile by an average of 2.07% over the next year. The analogous number using four-quarter net returns is 1.28% over the next year. The inverse relationship between fund size and performance is somewhat dampened but is still economically and statistically significant when we use other performance benchmarks. For instance, the corresponding numbers for gross and net