Proper fund size: a perspective from both investors and fund managers

Abstract

This paper proposes the notion of the proper size interval for funds and the market redemption return in fund markets. We establish a model to determine the proper size interval that accounts for the interests of both investors and fund managers as well as market constraints. We then propose a method to analyze fund managers’ abilities and fund sizes compared to the market averages. Using data on Chinese equity and hybrid funds for the sample period from 2009 to 2019, we find that there is a negative log-linear relationship between fund net excess return and fund size. Our model shows that both equity and hybrid funds experience the transition from being over-sized to properly- and under-sized. Under-sized and over-sized funds account for about 60% and 30% of the total sample, respectively, while less than 10% of funds have a proper size. Compared with over- or under-sized funds, funds with a proper size can generate higher returns and higher capital inflow. Our empirical results confirm that funds with higher managerial ability indeed outperform those funds with lower managerial ability, regardless of the category of fund size. Overall, our model provides a new method for fund investors, managers, and regulators to classify and evaluate funds.

Keywords:

• Investment funds
• fund size
• proper fund size interval
• market redemption return

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 Previous studies document that funds’ long-term robust operations can be achieved as long as fund managers can obtain a certain level of compensation, while fund investors can achieve their expected returns (Golec and Starks 2004; Wang and Tian 2009; Wang et al. 2015). Failing to satisfy the interests of both fund managers and investors can lead to a severe moral hazard problem in funds and can exacerbate the conflicts of interest between investors and managers, triggering a large-scale redemption or even fund liquidation.

2 In the empirical analysis, we find that the management fee is slightly different between equity and hybrid funds, but the fee rate is generally the same for the same type of fund.

3 In Section 3.2.2, we will provide empirical evidence showing the existence of the market redemption return.

4 In this paper, start-up funds are defined as those that were founded within two years, while funds that have been operating for more than two years are labeled as non-start-up funds. Start-up funds suffer from inconsistent operations, volatile returns, and incomplete historical data.

5 If the fund intentionally limits its size, $q_{i,t}$ could be lower than $q_{t,\mathcal{F}I}^{i\ast }$. However, the size should be kept above a certain thresholde level; otherwise, the return is too low and can be even lower than the redemption return (Indro et al. 1999).

6 For example, on Dec 31, 2019, a fund announced that its AUM was lower than 50 million Yuan for 60 consecutive trading days, which means that the liquidation disposition period is from October 1 to December 31, 2019. We then use data on the fund’s net excess returns from September 1, 2018 to September 30, 2019 to estimate market redemption returns.

7 We use three year rolling windows to estimate ${\hat{b}}_t$.

8 Starting from the beginning of 2016, China implemented the circuit breakers in the A-share market in order to prevent market crashes from occurring. Under this circuit breaker system, if the CSI 300 index changes by 5% from its previous close, then both the Shanghai and Shenzhen stock exchanges will halt trading for 15 minutes. If the index changes by 7% from the previous close, then trading will be halted for the day. On the first day of trading on January 4, 2016, the market dropped significantly, hitting the two levels of circuit breakers and about 1,500 stocks hit their daily lower limits. In January, the Shanghai Stock Index and Shenzhen Stock Index decreased by 22.65% and 25.64%.

Additional information

Funding

This work was supported by National Natural Science Foundation of China: [Grant Number 71771056]; Shanghai Philosophy and Social Science Planning Project: [Grant Number 2018EJB005].