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 that new money flows into funds with the highest past returns. The traditional interpretation is that fund managers are unskilled and fund investors are unsophisticated. Berk and Green (2004) offer an alternative, arguing that more-skilled managers will manage more assets but, because of diseconomies of scale, will generate the same expected returns as less-skilled managers. In their model, cross-sectional regressions of fund returns on fund size will significantly underestimate true diseconomies of scale. To identify the causal impact of mutual fund size on performance, we exploit the fact that small differences in mutual fund returns can cause discrete changes in Morningstar ratings that, in turn, generate discrete differences in mutual fund size. The diseconomies of scale that we estimate using this regression discontinuity approach are not statistically distinguishable from those estimated in standard cross-sectional regressions. Consequently, any downward bias in performance persistence arising from diseconomies of scale is likely to be small. (JEL classification: G23, G24, G14)