Market Frictions, Investor Sophistication, and Persistence In Mutual Fund Performance
2018
If there are
diseconomiesof
scalein asset management, any predictability in
mutual fundperformance will be arbitraged away by rational investors seeking funds with the highest expected performance (Berk and Green, 2004). In contrast, the performance of US equity
mutual fundspersists through time. In this paper, we investigate whether market frictions can reconcile the assumptions of investor rationality and
diseconomiesof
scalewith the
empirical evidence. More specifically, we extend the model of Berk and Green (2004) to account for financial constraints and heterogeneity in investors' reservation returns reflecting the idea that less financially sophisticated investors face higher
search costs. In our model, both negative and positive expected fund performance are possible in equilibrium. Moreover, expected fund performance increases with expected managerial ability, which can explain the evidence on performance persistence. The model also implies that performance persistence increases with fund visibility, as fund visibility increases the proportion of unsophisticated investors in the fund. Consistently with this prediction, we report
empirical evidencefor the US equity fund market that diferences in performance are significantly less persistent among hard-to-find funds than otherwise similar funds.
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