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How Does Size Affect Mutual Fund Behavior?

There has been substantial progress in the development of the government bond market. Key steps include a lengthening of the yield curve, reduction in external exposure and diversification of the investor base. This has been supported by improved macroeconomic conditions, foreign investors entering the fixed rate segment of local currency government debt, and well designed microstructure reforms regarding issuance policy and auction process. As shown below, the government bond market has become more resilient to various risk factors. . | THE JOURNAL OF FINANCE VOL. LXIII NO. 6 DECEMBER 2008 How Does Size Affect Mutual Fund Behavior JOSHUA M. POLLET and MUNGO WILSON ABSTRACT If actively managed mutual funds suffer from diminishing returns to scale funds should alter investment behavior as assets under management increase. Although asset growth has little effect on the behavior of the typical fund we find that large funds and small-cap funds diversify their portfolios in response to growth. Greater diversification especially for small-cap funds is associated with better performance. Fund family growth is related to the introduction of new funds that hold different stocks from their existing siblings. Funds with many siblings diversify less rapidly as they grow suggesting that the fund family may influence a fund s portfolio strategy. The average equity mutual fund does not outperform the stock market and relatively few actively managed equity funds can persistently outperform passive investment strategies.1 The absence of superior performance for the average fund combined with the lack of performance persistence appears to suggest a lack of managerial skill. In the absence of skill why do actively managed funds manage so much money Berk and Green 2004 indicates that diminishing returns to scale can reconcile the lack of average outperformance and performance persistence with the existence of managerial skill. In their model money flows to a fund until the marginal dollar can no longer be invested advantageously. In this paper we investigate the effect of asset growth on aspects of fund investment behavior to identify more precisely the constraints acting on funds as they grow. Regardless of whether diminishing returns to scale should affect fund performance in equilibrium fund behavior should respond to constraints imposed by growth. How should a mutual fund invest new money Should it research a larger universe of investment ideas hiring new staff and expanding its research capabilities or should it