Question

Let's assume that there are decreasing returns to scale in mutual funds caused by
liquidity problems in scaling. This means that, holding everything else constant, there
is a negative relationship between mutual fund size and returns. For which type of
mutual fund do you think there is a stronger negative relationship between mutual
fund size and performance: a fund that invests in stocks from a large country like the
U.S. or a fund that invests in a smaller country like Belgium? Why?

Answer 1

Ans ) A decreasing returns to scale in mutual fund is related to the problem when the fund size or in technical terms the Asset under management is growing in terms of the value but the return earned in the form of NAV that is the net asset value for the fund investors are not increasing to the proportion of fund size. The funds investment are not adequately gererating returns for the investors .Holding too much cash is risky as can be a good strategy when the market falls but on the other hand when the market rises there is less time for the manager to allocate the fund in more appropriate manner. Also the large scale selling and buying due to the size of the mutual fund can lead to the the impact on the prices of the stock and some overpriced stock can be included in the portfolio. For a country like US which is the financial leader of the world , here the mutual fund industry is hugely diversed the Asset under management in United States mutual fund is very huge in terms of AUM hence there is a lot of funds invested in stocks as well there is huge reserves of cash. Since the size of mutual fund is huge hence the negative or the deminishing return to scale with respect to return is huge as there would be a case of managerial inefficiency which results in failure to read the sector specific information and it happens due to the motive to increase the Assets under management or to constantly increasing the size of the fund inoder to make it attractive. Hence the risk factors are huge in the US mutual fund than a relatively small country like Belgium.As when more and more investors are entering into a mutual fund they bought more cash and with this lead to a chance of ineffective allocation of the funds that can lead to negative fund size and return relations.