There are diseconomies of scale in active management stemming from the increased costs associated with larger transactions. As assets under management increase, position sizes also increase, and the portfolio return as a percentage of assets declines. Even though returns decline, wealth created (in dollars) increases, up to a point. This wealth-maximizing point is reached when the cost of additional trading exceeds the opportunity cost of not trading. Further growth in assets leads to an increase in unexecuted trades, hence larger opportunity costs and lower percentage returns. Total wealth created is unaffected by increased opportunity costs.
If the management fee is a fixed percentage of assets, client wealth declines as opportunity costs rise, creating a divergence between firm and client interests. With performance fees, there is less of a problem: The firm loses revenues if accounts are added (and the assets traded) beyond the wealth-maximizing amount. Performance fees are a way of giving good firms sufficient inducement to contain their growth.
With diseconomies of scale, new clients dilute the returns to existing clients. Client ownership of a portion of the firm or its revenue stream is a potential solution to this problem.
