AbstractIf there are diseconomies of scale in asset management, any predictability in mutual fund performance will be arbitraged away by rational investors seeking funds with the highest expected performance (Berk and Green, 2004). In contrast, the performance of equity mutual funds persists through time. In this paper, we show how market frictions can reconcile the assumptions of investor rationality and diseconomies of scale with the empirical evidence. More specifically, we extend the model of Berk and Green (2004) to account for financial constraints and heterogeneity in investors' reservation returns reflecting the idea that less financially sophisticated investors face higher search costs. In our model, both negative and positive expected fund performance are possible in equilibrium. The model also predicts that expected fund performance increases with managerial ability and explains why predictable differences in performance across funds are more prevalent in markets populated by less sophisticated investors.