Size Matters: Small Mutual Funds Outperform Larger Peers

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Fund inflows reduce returns of management team

Fund size has a negative effect on average mutual funds’ performance. Chen, Hong, Huang and Kubik’s 2004 study and a 2008 study they conducted with Yan show that mutual funds with lower assets under management outperform competitors with larger asset bases. A study by Berk and Green done in 2004 suggests that higher inflows hinder excess returns depending on chosen benchmark.

David Blake, Tristan Caulfield, Christos Loannidis and Ian Tonks in their June 2014 discussion paper measure effects of fund size, fund family size, bid-ask spread and management charges on performance. Their sample is comprised of 561 UK domestic equity mutual funds and returns are measured over 129 months from January 1998 to September 2008.

Source: Pensions Institute Discussion Paper PI-1405

When Blake, Caulfield, Loannidis and Tonks consider size in their model, they find that excess returns are either negative or zero. This confirms 2004 findings by Chen, Hong, Huang and Kubik. It is probable that executing trades in batches to minimize effect on markets is hindering performance. To enhance returns to investors, funds can be split when they reach a certain size.

Education level of fund manager affects performance

Chevalier and Ellison show in their 1999 study that a fund’s manager educational level may account for performance differences among funds. Educational level is measured by the quality of university the manager attended and degree attained.

Manager changes dampen returns

Khorana’s 1996 study and Chevalier and Ellison’s 1999 study show that management changes have a negative effect on fund performance. If a top fund manager moves to a larger fund within the same organization or to another fund family, it reduces performance of the fund they left.

Degree of fund diversification within fund family reduces returns

According to Massa’s 2003 study, fund families that house mutual funds with different investment objectives are trying to differentiate their offerings. The study finds that such product differentiation hinders returns.

Blake, Caulfield, Loannidis and Tonks measure fund family size in terms of assets under management. They find that a higher assets under management under a given fund family reduces returns. Since fund families with more product offerings tend to have higher assets under management, findings are consistent with Massa’s 2003 study.

Mutual funds do not outperform net of fees

Blake, Caulfield, Loannidis and Tonks note in their June 2014 working paper that equally weighted monthly gross mutual fund return is 0.45% compared with the average monthly return of 0.36% for the FT All Share Index. The average net of fee return is 0.35%. The average monthly management fee is 0.11%. The results show that fund managers on average do not outperform an index net of fees between January 1998 and September 2008.

The full study can be found here wp1405

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