On Valuation And Liquidity Motivated Mutual Fund Trading
University of Augsburg
University of Augsburg
University of Augsburg
University of Augsburg
November 25, 2015
Abstract:
We develop an innovative approach to accurately differentiating between mutual funds’ valuation-motivated and liquidity-motivated trades on single trade level. Applying our Trade Motivation Matrix (TMM) to a large population of mutual fund trades in US stocks, we find significant outperformance of valuation-motivated buys over valuation-motivated sells, indicating the existence of stock picking skills. This outperformance is especially valuable during illiquid market periods as mispricing increases. Moreover, we find significant outperformance of valuation-motivated trades over liquidity-motivated trades indicating that mutual funds suffer significantly from adverse effects through investors’ supply and demand for liquidity. This adverse effect also increases during illiquid times, as it is more costly to provide liquidity to investors when facing limited market liquidity.
On Valuation And Liquidity Motivated Mutual Fund Trading – Introduction
Accurately distinguishing mutual funds’ valuation-motivated trades from their liquidity-motivated trades is of vital importance when assessing whether mutual funds are skilled or not. Only the performance of a fund’s voluntary trades based on valuation beliefs allow inferences on skill while the performance of their involuntary trades based on investors’ liquidity needs may be thought of as noise trading. Thus, any performance difference between voluntary and involuntary trades represents the costs of providing liquidity to investors. In this paper, we are the first to present evidence on the performance of mutual funds’ valuation-motivated and liquidity-motivated trades on the single (holdings based) trade level, thereby allowing for a more accurate assessment of mutual fund skill and costs of liquidity provision compared to previous studies. We apply a novel and innovative approach to identifying single valuation-motivated and liquidity-motivated trades, the Trade Motivation Matrix (TMM), to a sample of over 4.7 million single trades of US domestic equity funds. Our empirical findings reveal (i) that funds’ valuation-motivated buys outperform their valuation-motivated sells on average indicating the existence of fund manager skill; (ii) that skill is especially valuable during times of high valuation uncertainty as this outperformance is greater if market liquidity is low; (iii) that funds’ valuation-motivated trades outperform their liquidity-motivated trades indicating that mutual funds suffer substantially from flow risk and that liquidity provision to investors is costly; and (iv) that the adverse effects of liquidity-motivated trading is more pronounced during times of low market liquidity as it is more costly to provide liquidity to investors when facing limited market liquidity.
To sort each single mutual fund trade into the Trade Motivation Matrix (TMM), we combine two very intuitive measures. As shown in Figure 1, we first sort all trades into buys and sells using the change in a stock’s shares held by a fund from one holding report to the next (e.g., Chen et al., 2000). We then sort all trades into valuation-motivated and liquidity-motivated trades using the change in portfolio weights resulting from the trade. Specifically, if a buy (sell) trade increases (decreases) a fund’s portfolio weight in a stock, the manager has a positive (negative) valuation update regarding this stock. Such valuation-motivated trades are independent of investor flows and may occur at any time. If, on the other hand, a buy trade does not change the stock’s portfolio weight in the fund or even decreases it, the manager has no valuation update regarding this stock and simply scales up the existing holding as a reaction to investor inflows (e.g., Pollet and Wilson, 2008). Similarly, if a sell trade does not change a fund’s portfolio weight in a stock or even increases it, the manager scales down the existing holding as a reaction to investor outflows.
The TMM builds on various popular streams of mutual fund research. The flow-performance relation and the potentially adverse effect of investor flows on the discretion of open-end mutual fund managers, i.e. flow risk, was first empirically investigated by Edelen (1999). Using information on gross investor flows and aggregated fund trading (sales and purchases) from the SEC’s regulatory filings, Edelen finds that the general underperformance of actively managed funds compared to passive alternatives can partly be explained by flow-induced liquidity-motivated trading. Based on an updated and larger regulatory dataset, Dubofsky (2010) as well as Fulkerson and Riley (2015) confirm the strong relation between investor gross flows and aggregated mutual fund trading. Using daily implied net flows, Rakowski (2010) also find adverse effects of flow volatility on mutual fund performance. Also using the regulatory data from the SEC’s NSAR filings, Rohleder et al. (2015) show that some mutual funds possess the valuable skill of managing flow risk through the use of derivatives, thereby partly mitigating the adverse effects of flows on performance.
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