NBER Publications by Pengjie Gao

We show that a mutual fund's "stock selection skill" computed using the Daniel, Grinblatt, Titman and Wermers (1997) procedure can be decomposed into additional components that include impatient "informed trading" and "liquidity provision," thereby helping us understand how a fund creates value. We validate our method by verifying that liquidity provision is the dominant component of selection skill for Dimensional Fund Advisors U.S. Micro Cap fund, as observed by Keim (1999). Index funds lose on liquidity absorbing trades, since they pay the price impact on trades triggered by index rebalancing, inflows and redemptions. Consistent with the view that a mutual fund manager with superior stock selection ability is more likely to benefit from trading in stocks affected by information events, ...

We conjecture that a mutual fund manager with superior stock selection ability is more likely to benefit from trading in stocks affected by information-events. Taking the probability of informed trading (PIN, Easley, Kiefer, O'Hara, and Paperman, 1996) to measure the amount of informed trading in a stock, and inferring mutual fund trades from a large sample of mutual fund holdings, we provide empirical support for the conjecture. Funds trading high-PIN stocks exhibit superior performance on average, and superior performance that is more likely to persist. The findings are not due to price momentum or the higher returns earned by high-PIN stocks on average. Conclusions remain the same after testing for alternative measures for the amount of informed trading. Decomposing a fund's stock selec...