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Economies of Scale in the Real Estate Mutual Fund Industry

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Abstract

This paper investigates the role of scale in Real Estate Mutual Fund (REMF) performance. We test the impact of both fund-level and industry-level economies of scale on fund performance. We provide consistent evidence that industry size erodes REMF performance. After controlling for endogeneity concerns, we document an insignificant relation between fund size and performance. Taken together, these findings suggest that the rapid growth of the REMF industry over the past few decades has materially impacted active managers’ ability to consistently outperform their passive benchmarks. As more capital flows into the industry, competition for alpha increases, and investment opportunities dwindle. This effect is stronger in funds who are especially active in seeking out those increasingly elusive opportunities. Specifically, the effect of industry size on alpha is particularly negative for funds with higher turnover ratios, expense ratios, and volatility of returns.

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Notes

  1. https://www.spindices.com/spiva/#/reports.

  2. This sentiment is well-captured by a quote from David Lee, the portfolio manager of the T. Rowe Price Real Estate Funds following a period of outperformance: “While investors tend to look at REITs as a group, mutual fund managers know to slice the market into areas that behave differently during economic cycles.” Real Estate Funds Defy Forecasts with 27.6% 2010 Gain,” USA Today, January 6, 2011 (Kaushik & Pennathur, 2013).

  3. A few examples of earlier work on the effect of scale in mutual fund performance include Tufano and Sevick (1997) who argue cost savings at scale improve performance and Perold and Salomon (1991) who discuss price impact of large transactions driving diseconomies of scale for funds.

  4. Consistent with this, Chen et al. (2004) and Yan (2008) focus on liquidity constraints (price impact) as the mechanism and show that fund size erodes alpha. Other work on the topic includes Pollet & Wilson (2008), Ferreira et al. (2012), Reuter and Zitzewitz (2021), and Zhu (2018).

  5. The higher transparency is due to the simplicity of their operations (i.e., buy and operate real estate) along with the fact that they disclose the underlying property portfolios.

  6. “The fund manager has to know when to say when, especially in the case of small-cap funds. The fund should stay small and nimble. If it becomes too large, then performance will dwindle.” Steven Roge, Roge Partners Fund (Link: https://www.thestreet.com/investing/funds/mutual-funds/mutual-fund-bets-on-managers-not-stocks-11015545).

  7. Ro and Gallimore (2014) also focus on fund holdings to examine herding and momentum trading. They find that neither are particularly productive trading strategies for REMFs.

  8. Another notable investigation of fund level determinants on performance is Lantushenko and Nelling (2020) who examine activeness measures and find no consistent evidence that REMF activeness impacts alpha.

  9. Kallberg et al. (2000), Lin and Yung (2004), and Kaushik and Pennathur (2012) document a positive relation. Chou and Hardin (2014) and MacGregor et al. (2020) document a negative relation. Edward and Daniel (2000), Lantushenko and Nelling (2019), Hartzell et al. (2010) document no relation.

  10. Zhu (2018) challenge the empirical method of Pástor et al. (2015) and after altering the method find a negative relation between fund size and fund performance. We utilize the model of both Pástor et al. (2015) and Zhu (2018) for robustness.

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Acknowledgements

We are grateful for helpful comments from Michael O’Doherty, Takeshi Nishikawa, and participants at the American Real Estate Society (ARES) 2021 annual meeting.

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Authors and Affiliations

  1. University of Colorado, Colorado Springs, CO, 80919, USA

    Ryan G. Chacon

  2. Oakland University, Rochester, MI, 48309, USA

    Pratik Kothari

  3. Elon University, Elon, NC, 27244, USA

    Thibaut G. Morillon

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  1. Ryan G. Chacon
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Correspondence to Ryan G. Chacon.

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Table 9 Variable definitions
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Chacon, R.G., Kothari, P. & Morillon, T.G. Economies of Scale in the Real Estate Mutual Fund Industry. J Real Estate Finan Econ (2022). https://doi.org/10.1007/s11146-022-09921-0

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