What is it about?
Study the relation between liquidity risk and active mutual fund performance.
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Why is it important?
Active funds’ alpha is likely to be positively relate to its liquidity beta risk. This is because mispricing corrects more and informed investors trade more aggressively when liquidity improves. We highlight that the interpretation of liquidity risk of active mutual funds is more complex than that of traditional assets because of an endogenous feedback loop between informed investors, market liquidity, and mispricing correction.
Perspectives
o the ability of fund managers to create value depends on market liquidity conditions o the rate of mispricing correction is higher during improved liquidity periods o the intensity of informed trading and its profits is also higher during improved liquidity periods The recent financial crisis has provoked serious discussions among academics and investment professionals on the importance of understanding the risk-adjusted performance of financial institutions. Our findings call for caution when it comes to evaluating the liquidity risk of active funds. The essential role of liquidity in achieving efficient prices and in arbitrage trading suggests that active managers able to identify and dynamically trade mispriced stocks may well be liquidity risk takers at the same time. That is, they introduce liquidity beta to achieve their performance.
Professor Xi Dong
City University of New York System
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This page is a summary of: Liquidity Risk and Mutual Fund Performance, Management Science, October 2017, INFORMS,
DOI: 10.1287/mnsc.2017.2851.
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