Liquidity Risk And Mutual Fund Performance

This paper demonstrates that the ability of fund managers to create value depends on market liquidity conditions, which in turn introduces a liquidity risk exposure (beta) for skilled managers. We document an annual liquidity beta performance spread of 4% in the cross section of mutual funds over the period 1983-2014. Liquidity risk premia explain an insubstantial fraction of this spread; instead, the spread can be attributed to the differential ability of high liquidity beta funds to outperform across high and low market liquidity states, due to a differential rate of either mispricing correction or intensity of informed trading. Tests based on mispricing, proxied by a comprehensive set of 68 anomalies, and tick-by-tick trades, from a large proprietary institutional trading data set, corroborate the contribution of these channels. The results highlight the interaction between informed investors, mispricing, and liquidity beta.