Why Mutual Fund Alpha May Decline as Fund Size Grows
Summary
The document discusses why a mutual fund’s measured active return may fall as assets under management rise. One explanation is statistical: smaller funds have more variable outcomes, so they are more likely to appear among both unusually strong and unusually weak performers. Combining multiple positions or subportfolios can also dilute the impact of an exceptional result when performance is viewed in aggregate.
A second explanation, attributed to the academic concept of decreasing returns to ability, is that managers deploy capital first in their best opportunities. As assets grow, they must invest in less attractive remaining opportunities, lowering expected returns. The discussion points to the Berk and Green model, in which investor flows expand successful managers’ funds until expected returns become competitive. The document offers conceptual explanations rather than a fresh empirical test, and the final answer begins an allocator’s experience-based perspective but provides no supporting details in the excerpt. These mechanisms may help interpret size and performance patterns, but the text does not establish that they explain every fund or market.
Key ideas
- Smaller funds can show more extreme measured returns because their outcomes vary more.
- Aggregating many positions can dilute the effect of an unusually strong holding.
- Managers may invest first in their most attractive opportunities, then use less profitable ones as assets grow.
- Competitive investor flows can expand a successful fund until its expected returns approach benchmark levels.
Tags
Full text
# Fund size and alpha # Fund size and alpha During my research I found that fund active returns (alpha), measured by Fama and French four factor model, decreases as the fund increases in size (asset under management). What are some reasons that explains such relationship? ## Answer by Phil H (score 2) https://quant.stackexchange.com/a/39903 Most of this will be the sheer nature of statistics. Big funds tend to have more average results, small funds have more variance and thus have more of the high returns, but also likely more of the heavy losses. The same statistical effect is visible in the context of school performance : https://marginalrevolution.com/marginalrevolution/2010/09/the-small-schools-myth.html An alternative way to view it is that a large fund could be divided into several smaller funds, each representing a part of the portfolio. Keeping them separate, a stellar year in a large fund's credit position would stand out, but averaged in with the other positions (even if they are no worse than market average) would dilute the effect. ## Answer by phdstudent (score 2) https://quant.stackexchange.com/a/39904 The main reason in the academic literature for alphas to decrease with fund size has to do with decreasing returns to ability. Think about it this way: - Managers first allocate funds to the most profitable opportunities; So the first dollars invested in fund have high returns (and so small funds perform well); - As the fund size increases managers allocate money to the remaining available opportunities that are not as good as the first ones and therefore overall returns decrease. The effect above that I described in words is called decreasing returns to ability. It was first highlighted by Berk and Green in their paper Mutual Fund Flows and Performance in Rational Markets. In their own words: > In our model, investments with active managers do not outperform passive benchmarks because investors competitively supply funds to managers and there are decreasing returns for managers in deploying their superior ability. Managers increase the size of their funds, and their own compensation, to the point at which expected returns to investors are competitive going forward. Check the paper for the algebra of the model and more intuition. ## Answer by Helin (score 1) https://quant.stackexchange.com/a/39906 I thought I'd contribute an answer that's more empirical and experience-based. I worked at an asset allocator earlier on in my career, and the company has a very strong bias toward NOT investing in large funds. Several reasons drive this bias:
Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.