Asset Fire Sales, Liquidity Provision, and Mutual Fund Performance

Abstract

This paper investigates whether some mutual funds benefit from providing liquidity to other funds in financial distress - those that are experiencing severe money outflows. Forced trades by distressed funds generate temporary downward price pressure on securities held in common by these funds and therefore create trading opportunities for outside investors. This paper shows that some mutual fund managers have the ability to consistently identify and purchase these fire-sale stocks and that they benefit from providing liquidity to distressed funds. Moreover, these managers exhibit overall investment skills beyond identifying fire-sale stocks, which lead to superior performance in the rest of their portfolios. The performance results remain robust after adjusting for risk and controlling for fund attributes, such as fund flows and turnover.

Keywords: Liqudity Provision, Mutual Fund Performance, Financial Distress, Price Pressure

JEL Classification: G10, G14, G23