Market frictions, investor heterogeneity, and persistence in mutual fund performance

We investigate whether market frictions can reconcile the assumptions of investor rationality and diseconomies of scale of the Berk and Green (2004) model with the empirical evidence that mutual fund performance persists over time. We show that when investors are financially constrained and there is heterogeneity in investors' reservation returns, expected fund risk-adjusted returns are not zero in equilibrium. Moreover, expected fund performance increases with managerial ability. Therefore, if managerial ability persists over time, so does fund performance. Finally, the model implies that predictable differences in performance across funds are more prevalent in markets populated by less sophisticated investors.