Capital Allocation and the Market for Mutual Funds: Inspecting the Mechanism

Jules H. van Binsbergen, Jeong Ho (John) Kim, and Soohun Kim

♦ We exploit heterogeneity in decreasing returns to scale parameters across mutual funds to analyze the importance of scalability for investors’ capital allocation decisions. We find strong evidence that steeper decreasing returns to scale attenuate flow sensitivity to performance. We calibrate a rational model of active fund management and show that a large fraction of cross-sectional variation in assets-under-management is due to investors anticipating the effects of scale on return performance. We conclude that decreasing returns to scale play a key role in achieving equilibrium in the intermediated investment management market.

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