Fund Tradeoffs

Ľubo š Pastor, Robert F. Stambaugh and Lucian A. Taylor
Forthcoming in the Journal of Financial Economics

• Mutual funds manage tens of trillions of dollars, playing a major role in allocating capital in the economy. What drives these funds’ portfolio choices?
• Pastor, Stambaugh & Taylor (2020) show that funds’ portfolio choices depend crucially on diseconomies of scale, the idea that larger funds have higher trading costs, which hurts their performance.
• The authors show that larger funds optimally reduce their trading costs by being less active, in two ways: they trade less, and they hold more-liquid portfolios.
• It is common to think about the liquidity of individual stocks. But how should we think about the liquidity of a portfolio of stocks? The authors show that portfolio liquidity depends not only on the liquidity of the stocks in the portfolio, but also on the portfolio’s diversification. More-diversified portfolios are more liquid.
• There has been a major change in the mutual fund industry: Funds’ average portfolio liquidity roughly doubled from 1979-2014, driven by a quadrupling of portfolio diversification. Active mutual funds look increasingly like passive index funds.