Big Funds are Not Beautiful, says Academic Study

If you want to keep outperforming, stay—or become—small.

(June 19, 2014) -- Loading capital in to the largest funds may mean cutting back on your alpha potential, a study published by London’s Cass Business School has claimed.

David Blake, founder of the university’s Pensions Institute, Tristan Caulfield of City University London, and Christos Ioannidis and Ian Tonks from the University of Bath, pooled their expertise to study the effect of funds—and other significant factors—on its performance in a paper entitled “Improved Inference in the Evaluation of Mutual Fund Performance using Panel Bootstrap Methods”.

“Using a dataset of UK equity mutual fund returns, we find that fund size has a negative effect on the average fund manager’s benchmark-adjusted performance,” the paper said.

The authors created a new framework through which to measure fund performance, arguing that the current standard set-up omits factors that are essential for investors to consider.  It also used a universe of funds free of survivorship bias, by including those that were both created and liquidated between January 1998 and September 2008.

Performance and management fees were deducted from final figures but entrance and exit were not counted.

“The coefficient on fund size is negative and highly significant indicating that increasing fund size has a material effect in lowering a fund’s performance,” the paper said.

The paper’s authors examined the effect of most highly educated managers coming into the largest fund groups and found they rarely outperformed in this environment. In fact, the move usually had a detrimental effect.

“Once we control for fund size and other fund-specific factors—in particular, family fund size—the average fund manager’s alpha for both gross and net returns is insignificantly different from zero,” the authors said. “This implies that if better qualified managers do manage the largest funds in the largest fund families—which is entirely plausible—they do not appear to deliver outperformance: in other words, the size of the fund overwhelms any superior skills they might have.”

The authors suggested that successful funds, which received increasing levels of inflows, should consider splitting in order to maintain results.

“Since the most likely explanation for the negative relationship between fund size and performance is the negative market impact effect from large funds attempting to trade in size, this suggests that funds should split themselves up when they get to a certain size in order to improve the return to investors.”

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