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Liquidity Style of Mutual Funds

Last Updated on 10 February, 2024 by Rejaul Karim

The paper “Liquidity Style of Mutual Funds” by Thomas M. Idzorek, James X. Xiong, and Roger G. Ibbotson explores the relationship between liquidity and mutual fund performance. The authors examine whether a liquidity investment style – investing in relatively less liquid stocks within the liquid universe of publicly traded stocks – can be uncovered at the mutual fund level.

They find that mutual funds that held less liquid stocks significantly outperformed mutual funds that held more liquid stocks across a wide range of mutual fund categories. This demonstrates that the liquidity premium is sufficiently strong to show up in portfolios where the managers are most likely not directly focusing on liquidity.

The paper also finds that the outperformance of the mutual funds that held less liquid stocks was primarily due to superior performance in down markets, especially market crashes.

Abstract Of Paper

Recent literature indicates that a liquidity investment style – the process of investing in relatively less liquid stocks within the liquid universe of publicly traded stocks – has led to excess returns relative to size and value. While previously documented at the security level, we examine whether this style can be uncovered at the mutual fund level. In aggregate and across a wide range of mutual fund categories, we find that on average mutual funds that held less liquid stocks significantly outperformed mutual funds that held more liquid stocks. This demonstrates that the liquidity premium is sufficiently strong to show up in portfolios where the managers are most likely not directly focusing on liquidity. Surprisingly, the outperformance of the mutual funds that held less liquid stocks was primarily due to superior performance in down markets, especially market crashes.

Original paper – Download PDF

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Author

Thomas M. Idzorek
Morningstar Investment Management

James X. Xiong
Morningstar Investment Management

Roger G. Ibbotson
Yale School of Management; Zebra Capital Management, LLC

Conclusion

The paper “Liquidity Style of Mutual Funds” by Thomas M. Idzorek, James X. Xiong, and Roger G. Ibbotson concludes that mutual funds that held less liquid stocks significantly outperformed mutual funds that held more liquid stocks across a wide range of mutual fund categories.

The authors use a liquidity investment style – the process of investing in relatively less liquid stocks within the liquid universe of publicly traded stocks – to demonstrate that this style can be uncovered at the mutual fund level.

The paper highlights the significant variation in abnormal returns across different mutual fund categories. The findings of the paper provide strong evidence to support the liquidity premium theory.

Moreover, the paper finds that the outperformance of the mutual funds that held less liquid stocks was primarily due to superior performance in down markets, especially market crashes.

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FAQ

What is the main focus of the paper “Liquidity Style of Mutual Funds”?

The paper explores the relationship between liquidity and mutual fund performance, specifically investigating whether a liquidity investment style, characterized by investing in relatively less liquid stocks within the liquid universe of publicly traded stocks, can be identified at the mutual fund level.

What is the key finding regarding mutual fund performance based on liquidity investment style?

The paper finds that, on average, mutual funds that held less liquid stocks significantly outperformed mutual funds that held more liquid stocks across a broad range of mutual fund categories. This suggests that the liquidity premium, previously documented at the security level, is strong enough to manifest at the portfolio level, even when fund managers may not be explicitly focusing on liquidity.

How does the paper contribute to the understanding of liquidity premium in mutual funds?

The paper contributes to the understanding of the liquidity premium by demonstrating its impact on mutual fund performance. The findings suggest that the liquidity premium is a significant factor that influences the returns of mutual funds, and this influence is observed across various fund categories.

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