Market frictions, investor heterogeneity and persistence in mutual fund performance

If there are diseconomies of scale in asset management, any predictability in mutual fund performancewill be arbitraged away by rational investors seeking funds with the highest expectedperformance (Berk and Green, 2004). In contrast, the performance of equity mutual funds persiststhrough time. In this paper, we show how market frictions can reconcile the assumptions ofinvestor rationality and diseconomies of scale with the empirical evidence. More specifically, weextend the model of Berk and Green (2004) to account for financial constraints and heterogeneityin investors reservation returns reflecting the idea that less financially sophisticated investorsface higher search costs. In our model, both negative and positive expected fund performanceare possible in equilibrium. The model also predicts that expected fund performance increaseswith managerial ability and explains why predictable differences in performance across fundsare more prevalent in markets populated by less sophisticated investors