Does Liquidity Beta Predict Mutual-Fund Alpha?

Abstract:     
This paper demonstrates that the systematic liquidity-risk exposures of mutual funds can predict outperformance in the cross-section. Funds that significantly load on liquidity risk subsequently outperform low-loading funds by about 6% annually over the period 1984--2009. Four possible explanations for this effect are tested: (a) liquidity-risk premium; (b) managerial skill; (c) funding-liquidity premium; and (d) cost-based explanations including funds' liquidity levels, transaction costs, and operational costs. We find that the liquidity-risk premium of fund holdings explains only a small portion of the effect. Evidence suggests that the remaining portion is more likely due to managerial ability in generating abnormal performance than to the other explanations.

Number of Pages in PDF File: 56

Keywords: Liquidity risk, Finanical Institutions, Price impact, Asset pricing

JEL Classification: G12, G14

working papers series