Informed Trading, Liquidity Provision, and Stock Selection by Mutual Funds

Zhi Da, Pengjie Gao and Ravi Jagannathan

No 14609, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: G00 G11 G12 G2 (search for similar items in EconPapers)
Date: 2008-12
New Economics Papers: this item is included in nep-mst
Note: AP
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Citations: View citations in EconPapers (1)

Published as Da, Zhi, Re-Jin Guo and Ravi Jagannathan. 2012. CAPM for Estimating the Cost of Equity Capital: Interpreting the Empirical Evidence. Journal of Financial Economics. 103(1): 204-220.

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