Adverse Scale Effect and Managerial Skill in Mutual Funds: Evidence from Corporate Bond Mutual Funds

Abstract

This paper examines a sample of corporate bond mutual funds to explore the presence of a decreasing returns to scale effect among mutual funds. Initial results show that on average, fund performance decreases by 13.85 basis points per year when the fund size increases by one standard deviation. The negative and significant relation between fund performance and fund size persists when various robustness tests are conducted. Further results show that the negative effect of scale on performance is related to illiquidity effects, since performance of mutual funds that hold high yield bonds – the least liquid bonds – decreases by a factor of ten times the performance of other funds as size increases. Given the adverse effect of size on performance, we reevaluate the fund manager’s skill. Unlike the common belief that fund managers are not skilled on average, our results indicate that corporate bond mutual fund managers are skilled. Finally, by sorting managers based on their skills, we find that highly skilled managers persistently generate more than 2 million dollars per month for up to 12 months into the future. It implies that a manager’s skill is persistent, and performance is not attributable to luck.