Informed Trading, Liquidity Provision, and Stock Selection by Mutual Funds
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 find that funds trading such stocks exhibit superior performance that is more likely to persist. Further, such superior performance comes mostly from impatient informed trading. We also find that informed trading is more important for growth-oriented funds while liquidity provision is more important for younger funds with income orientation.
We thank Robert Battalio, Jonathan Berk, Roger Edelen, Craig Holden, Paul Irvine, Tim Loughran, Rick Mendenhall, David Musto, Lubos Pástor, Christine Parlour, Paul Schultz, Clemens Sialm, Laura Starks, Sheridan Titman, Charles Trzcinka, Lance Young and seminar participants at Northwestern University, IU/ND/Purdue Finance Symposium, University of Illinois at Urbana-Champaign, University of Michigan, Barclays Global Investors, Tilburg University, the 4th Vienna Symposium on Asset Management, FRA 2007 Annual Meeting, NBER Asset Pricing Meeting, the Western Finance Association 2008 Annual Meeting for comments. Some of the results in the paper appeared in "When does a mutual fund's trade reveal its skill?" (NBER WP# WP13625) by the same authors. Patricia Andersen provides excellent editorial support. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.