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

Abstract

We show that a mutual fund's stock selection skill can be decomposed into additional components that include impatient and 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.