If there are diseconomies of scale in asset management, any predictability in mutual fund performance
will be arbitraged away by rational investors seeking funds with the highest expected
performance (Berk and Green, 2004). In contrast, the performance of equity mutual funds persists
through time. In this paper, we show how market frictions can reconcile the assumptions of
investor rationality and diseconomies of scale with the empirical evidence. More specifically, we
extend the model of Berk and ...
If there are diseconomies of scale in asset management, any predictability in mutual fund performance
will be arbitraged away by rational investors seeking funds with the highest expected
performance (Berk and Green, 2004). In contrast, the performance of equity mutual funds persists
through time. In this paper, we show how market frictions can reconcile the assumptions of
investor rationality and diseconomies of scale with the empirical evidence. More specifically, we
extend the model of Berk and Green (2004) to account for financial constraints and heterogeneity
in investors reservation returns reflecting the idea that less financially sophisticated investors
face higher search costs. In our model, both negative and positive expected fund performance
are possible in equilibrium. The model also predicts that expected fund performance increases
with managerial ability and explains why predictable differences in performance across funds
are more prevalent in markets populated by less sophisticated investors.
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