Market Frictions, Investor Sophistication and Persistence in Mutual Fund Performance

If there are diseconomies of scale in asset management, any predictability in mutual fund performance 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 funds persists through time. In this paper, we investigate whether market frictions can reconcile the assumptions of investor rationality and diseconomies of scale with 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 evidence for the US equity fund market that diferences in performance are significantly less persistent among hard-to-find funds than otherwise similar funds.