A global sample of active funds underperforms the benchmark after fees by an average of 20 bps per quarter. For U.S. funds that invest domestically, a one standard deviation increase in fund size reduces performance by an average of 15 bps per quarter, but the penalty for a given increase in fund size is greater for funds that invest in small and illiquid stocks. In contrast, for funds that invest internationally, a corresponding increase in fund size raises performance by 11 bps per quarter, although this increase ceases to be significant when the lower size quintile is excluded. Management by individuals rather than teams also enhances performance.

Overall, caution is required when recommending actively managed funds, but the burden of proof is highest for large, domestically invested open-end U.S. funds that focus on small and illiquid stocks. Relative performance may be enhanced by avoiding active funds that are large, invested in the U.S. market, managed by teams rather than individuals, managed by firms with small fund families, and located in markets with poor liquidity, poor levels of financial development, or weak financial institutions. Funds in the smallest size quintile and that are investing internationally should also receive extra scrutiny or be avoided altogether.

Investment firms considering the viability of new active fund launches should consider constraints on fund size if they are targeting small U.S. firms or illiquid markets. When targeting international markets, medium to large funds may be more efficient, but locating the fund in a market that exhibits weak investor protection laws and financial development may be perceived as a negative signal to investors. When formulating investment processes, the assignment of decision-making responsibility to an individual appears more promising than team or committee-based decision making. When comparing individual managers within firms, performance attribution analysis should account for the possibility that it is harder to achieve superior performance in some types of funds than in others.

The authors use the Lipper Hindsight database to gather returns from 1997 to 2007 of 16,316 open-end actively managed mutual funds in 27 countries. They exclude duplicate share classes of the same funds, exchange-traded funds, closed-end funds, funds with less than two years of reported returns, and funds registered in offshore tax havens. The result is a sample free from survivorship bias.

For each fund, relative performance is measured using the quarterly intercept coefficient in the Carhart four-factor model, which is used to control for market, size, style, and momentum risk factors. Using panel regressions, the authors examine the associations between relative performance and the independent variables. They identify liquidity constraints as a factor that limits performance as fund size increases and argue that liquidity constraints are greater for domestically invested U.S. funds than for funds that invest outside the United States.

Average U.S. funds are five times larger than non-U.S. funds. So, to control for the possibility that the results are driven by funds that are substantially larger than funds in the non-U.S. sample, the authors estimate a panel regression using a sample that excludes U.S. funds that are larger than funds in the non-U.S. sample. Further robustness tests include the use of alternative return-generating models, such as a benchmark-adjusted return model, market model, and gross return model. Overall, the results are consistent across these robustness tests.

The authors provide an extensive analysis of mutual fund performance that should be invaluable to asset allocators in their fund selection decisions. One could infer from their results and discussion that positive scale economies arise from the administrative capabilities of larger management firms. But when fund size, distinct from management firm size, increases, these economies are offset by liquidity constraints in the investable universe. Increasing fund size may also increase the likelihood that investment decisions are made using teams rather than individual managers, which further hampers performance. The comparison of cross-country characteristics substantiates their overall contribution.