When Does a Mutual Fund's Trade Reveal its Skill?

Abstract:     
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 selection ability into "informed trading" and "liquidity provision" adds further insight into fund's underlying strengths. Impatient informed trading is a significant source of alpha for funds trading high-PIN stocks, while liquidity provision is more important as a source of alpha for funds trading low-PIN stocks.

Number of Pages in PDF File: 52

working papers series