Fund size, transaction costs and performance : size matters!

Recent studies find evidence that small funds outperform large funds. This fund size effect is commonly hypothesized to be caused by transaction costs. Due to the lack of transactions data, prior studies have investigated the transaction costs theory indirectly. Our study, however, analyses the daily transactions of active Australian equity managers and finds aggregate market impact costs incurred by large managers are significantly greater than those incurred by small managers. Furthermore, we show large managers exhibit preferences for trade package formation and portfolio characteristics consistent with transaction cost intimidation. We analyse the interaction between transaction cost intimidation and the fund size effect, and document that large managers pursuing a highly active trading strategy suffer more from fund size, than large funds following a more passive strategy. This suggests the fund size effect is related to transaction costs, as trading activity is a good proxy for expected market impact. Finally, based on a simulation experiment, we find that transaction cost intimidation is at least as important as the increase in market impact costs due to fund size.