Scale Effects in Mutual Fund Performance: The Role of Trading Costs

Capacity and factor timing effects in active portfoliomanagement

“…We are especially interested in those coefficient estimates that are unique to the capacity component, in order to better understand the characteristics of the fund and its underlying holdings that drive capacity constraints that are distinct from the timing of fund flows. Table 4 shows that the fund's turnover ratio takes a significant negative coefficient estimate for both capacity and timing components, which is consistent with Edelen, Evans, and Kadlec (2008), and implies that higher turnover is significantly linked to larger capacity constraints and more poorly timed fund flows. Fund size, cash holdings, and the 10 See Morningstar introduces new investor return Data to capture how the average investor fared in a fund over a period of time: Chicago, October 5, 2006-Morningstar, Inc., a leading provider of independent investment research, today announced it is providing new data for open-end mutual funds and exchange-traded funds to capture how the average investor fared in a fund over a period of time.…”

“…The branch of the literature that focuses on the liquidity cost aspect of flows argues that flow is costly to investors' performance because their flows are essentially ''poorly timed'' (Braverman, Kandel, and Wohl, 2005;Frazzini and Lamont, 2008) or their flows lower the funds' returns by causing the fund's managers to engage in costly transactions (Edelen, 1999;Dubofsky, 2010;Rakowski, 2010). Similarly, transaction costs are the focus of the diseconomies of scale in Edelen, Evans, and Kadlec (2008), where larger fund size is associated with lower performance through the increased trading costs associated with the fund having to use larger trade sizes. Chen, Hong, Huang, and Kubik (2004) find that mutual fund performance deteriorates with increases in fund size, but associate these scale diseconomies with fund management and fund sponsor operational characteristics and cost structures.…”

Do Mutual Funds Have Decreasing Returns to Scale? Evidence from Fund Mergers

“…He finds that funds which hold less liquid portfolios and which have high liquidity demand, such as growth funds and high-turnover funds, have a stronger negative relation between size and performance. Edelen, Evans, and Kadlec (2007) examine the role of trading costs as a source of decreasing returns to scale. They regress fund returns on both relative trade size and fund size, finding that relative trade size subsumes fund size in the regression.…”

“…Chen, Hong, Huang, and Kubik (2004), Edelen, Evans, and Kadlec (2007), and Yan (2008) document a significantly negative relation between size and performance. They show that liquidity and trading costs are the underlying factors driving the adverse effect of size on performance.…”

The Relation between Past Flows and Future Performance: Simple Investment Strategies in the Mutual Fund Sector

“…Liquidity service costs and liquidity trading are the most popular explanations for diseconomies of scale caused by fund flows (e.g., Green and Hodges [22]; Coval and Stafford [23]; Edelen et al [24]; Benson et al [25]). Besides offering a widely diversified portfolio at a reasonable cost, mutual funds provide a high level of liquidity to shareholders who can buy and sell at the fair net asset value on a daily basis (e.g., Gruber [12]; Edelen [26]).…”