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

56 Pages Posted: 15 Nov 2007 Last revised: 19 Dec 2008

See all articles by Zhi Da

Zhi Da

University of Notre Dame - Mendoza College of Business

Pengjie Gao

University of Notre Dame - Mendoza College of Business

Ravi Jagannathan

Northwestern University - Kellogg School of Management; National Bureau of Economic Research (NBER); Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF); Indian School of Business (ISB), Hyderabad

Multiple version iconThere are 2 versions of this paper

Date Written: December 16, 2008

Abstract

We show that a mutual fund's stock selection skill can be decomposed into additional components that include impatient "informed trading" and "liquidity provision." We validate our method by verifying that liquidity providing trades are the primary source of value for the Dimensional Fund Advisors U.S. Micro Cap fund, consistent with the observations by Keim (1999) and Cohen (2002); and 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: Informed Trading, Liquidity, Mutual Fund

JEL Classification: G1, G2

Suggested Citation

Da, Zhi and Gao, Pengjie and Jagannathan, Ravi, Informed Trading, Liquidity Provision, and Stock Selection by Mutual Funds (December 16, 2008). Available at SSRN: https://ssrn.com/abstract=1030111 or http://dx.doi.org/10.2139/ssrn.1030111

Zhi Da (Contact Author)

University of Notre Dame - Mendoza College of Business ( email )

Notre Dame, IN 46556-5646
United States

Pengjie Gao

University of Notre Dame - Mendoza College of Business ( email )

246 Mendoza College of Business
Notre Dame, IN 46556-5646
United States
(574) 631-8048 (Phone)

Ravi Jagannathan

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
429 Andersen Hall
Evanston, IL 60208
United States
847-491-8338 (Phone)
847-491-5719 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

Indian School of Business (ISB), Hyderabad ( email )

Hyderabad, Gachibowli 500 019
India

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