We study tradeoffs among active mutual funds' characteristics. In both our equilibrium model and the data, funds with larger size, lower expense ratio, and higher turnover hold more-liquid portfolios. Portfolio liquidity, a concept introduced here, depends not only on the liquidity of the portfolio's holdings but also on the portfolio's diversification. We also confirm other model-predicted tradeoffs: Larger funds are cheaper. Larger and cheaper funds are less active, based on our new measure of activeness. Better-diversified funds hold less-liquid stocks; they are also larger, cheaper, and trade more. These tradeoffs provide novel evidence of diseconomies of scale in active management.
This paper previously circulated under the title “Portfolio Liquidity and Diversification: Theory and Evidence.” The views in this paper are the responsibility of the authors, not the institutions they are affiliated with, nor of the National Bureau of Economic Research. We are grateful for comments from our conference discussants Daniel Andrei, James Choi, Wayne Ferson, Mark Grinblatt, Paul Irvine, Marcin Kacperczyk, Clemens Sialm, Ashish Tiwari, and Mungo Wilson. We are also grateful for comments from Jonathan Berk, Gene Fama, Laszlo Jakab, Don Keim, Rob Vishny, Jeff Wurgler, and Yao Zeng, conference participants at the AIM Investment Conference, AQR Insight Award Finalists Competition, Conference on Professional Asset Management (Erasmus), Duke/UNC Asset Pricing Conference, ESSFM Gerzensee, European Finance Association, FARFE (MIT), Five-Star Conference on Research in Finance (NYU Stern), GSU-CEAR Finance Conference, NBER Conference on New Developments in Long-Term Asset Management, Q Group, Western Finance Association, and seminar participants at Boston University, Tulane University, University of Chicago, University of Illinois at Urbana-Champaign, University of Pennsylvania, University of Utah, and WU Vienna. We are also grateful to Will Cassidy, Yeguang Chi, and Pierre Jaffard for superb research assistance. This research was funded in part by the Fama-Miller Center for Research in Finance and the Center for Research in Security Prices at Chicago Booth.
Pastor is a member of the governing board of the National Bank of Slovakia whose responsibilities include serving as the principal regulator of mutual funds in Slovakia. Yet the Bank has no stake in this research, no benefit from it, and no influence upon it.