A number of empirical studies have investigated how mutual funds do react to incoming financial resources. As long as liquidity constraints are narrow, fund managers tend to upscale already existing positions without looking for new investment opportunities.
Concomitantly, performance of funds decreases which is explained by the expansion of size-driven liquidity costs.
We put forward a model of asset allocation that accounts for market liquidity frictions and recovers the inverse relation between fund size and fund performance. The model prescribes how fund portfolio managers should react as financial resources enter the fund. We estimate the model on S&P 600 stock data and investigate optimal allocation behavior under fund size increase. We obtain that to confine the negative effect of liquidity frictions on performance, portfolio diversification should be increased under fund size increase. In particular, once a certain fund size is attained, fund managers should incorporate new investments which enhances portfolio diversity and reduces liquidity-driven performance erosion.