Working Paper: NBER ID: w14609
Authors: Zhi Da; Pengjie Gao; Ravi Jagannathan
Abstract: 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.
Keywords: mutual funds; stock selection; informed trading; liquidity provision
JEL Codes: G00; G11; G12; G2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| impatient informed trading (G14) | superior performance (D29) |
| liquidity provision (E41) | performance for younger income-oriented funds (G23) |
| informed trading (G14) | performance persistence (C41) |
| liquidity provision is critical for younger funds (G23) | performance (D29) |
| informed trading (G14) | performance for growth-oriented funds (L25) |
| trading high PIN stocks (G12) | higher returns (G12) |