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The Liquidity Style of Mutual Funds
Thomas M. Idzorek, CFA® President and Global Chief Investment Officer Morningstar Investment Management Chicago, Illinois James X. Xiong, Ph.D., CFA® Senior Research Consultant Morningstar Investment Management Chicago, Illinois Roger G. Ibbotson, Ph.D. Chairman & CIO Zebra Capital Management, LLC Professor in Practice Yale School of Management New Haven, Connecticut
June 2012
Forthcoming in the Financial Analysts Journal
The Liquidity Style of Mutual Funds
Page 2 of 21
Abstract
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 to many, the outperformance of the mutual funds that held less liquid stocks was primarily due to superior performance in down markets, especially market crashes.
The Liquidity Style of Mutual Funds
Page 3 of 21
Introduction
It is relatively well known that less liquid investments tend to outperform more liquid investments. The same holds true within the relatively liquid universe of publicly traded stocks. The generally accepted rationale for a liquidity premium is that all else equal, investors prefer greater liquidity; thus, in order to induce investors to hold less liquid assets, they must have the expectation (but not the guarantee) of a return premium. Using today’s nomenclature, one could think of...