On the Liquidity and Performance of U.S. Small-Cap Stock Mutual Funds 关于美国小盘股共同基金的流动性和绩效表现

1. On the Liquidity and Performance of U.S. Small-Cap Stock Mutual Funds关于美国小盘股共同基金的流动性和绩效表现 Bill Ding, Yongjia Li, Hany Shawky and Jianbo Tian State University of New York at Albany

2. Motivation • The current financial crisis in the US: • Liquidity problem in the credit-derivatives market due to high subprime default rate • Mark-to-Market Accounting • Government bailoutof financial institutions. • The mutual fund industry was hit hard due to the huge market negative return and outflows, but less hard than commercial banks, mortgage industry, hedge funds due to the law prohibiting them from taking high leverage. • As a response to the crisis, the Investment Company Institute (ICI), the mutual fund trade association, proposed the regulatory reform proposal in March 2009. http://www.ici.org/pdf/ppr_09_reg_reform.pdf • At the core, it calls for the creation and designation of a “systemic risk regulator.” • The segment of small-cap stock mutual funds is the segment in the mutual fund industry that is most likely to higher systemic risk than other segments. (Chen, Jiang, Goldstein (2008)) On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

3. Liquidity Crisis Source: http://www.americanprogress.org/cartoons/2009/02/020509.html On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

4. Growth Path of a Company • Life cycle of a firm: Start-Up, Pre-Listing, VC Involved IPO Small-Cap Stock Mid-Cap Stock Large-Cap Stock On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

5. Small-Cap Stocks • There are many--about 7,000--small stocks • Mostly traded on NASDAQ (Small-Cap market, OTC) (a few hundred traded on AMEX) • Very illiquid—less market breadth and depth • Non-synchronous trading, Lo and MacKinlay (1990) • Less market breadth and depth: “Illiquidity affects more strongly small firm stocks, thus explaining time series variations in their premiums over time.” (Amihud (2002)) • High idiosyncratic risk • Higher idiosyncratic business risk (uncertainty) due to growth • “We show that this result [positive volatility and stock return] is driven by small stocks traded on the Nasdaq, and is in part due to a liquidity premium.” (Bali, Cakici, Yan, and Zhang (2005)) • Small size premium puzzle & January effect (Roll (1984), Fama and French (1992)) • Small-size stocks (measured by market capitalization) tend to have higher return than large-size stocks, even after risk is accounted for. • Such premium is mostly earned in January. • Posed as an evidence against the Efficient Market Hypothesis On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

6. Small-Cap Stock Mutual Funds • Lipper’s definition: invest at least 75% of equity in companies with market capitalizations (on a three-year weighted basis) less than 250% of the dollar median of smallest 500 of the middle 1,000 securities of the S&P SuperComposite 1500 Index. (usually market cap. < $1 billion) • Growth: above average P/E, P/B, and three-year sales growth value, compared to S&P SmallCap 600 Index; also known as “aggressive growth” objective. • Value: below average P/E, P/B, and three-year sales growth value, compared to S&P SmallCap 600 Index • Core: about average P/E, P/B, and three-year sales growth value, compared to S&P SmallCap 600 Index • Since there is less analyst coverage for small-cap stocks, it is more likely to find private information in small-cap stocks. • If mutual funds can beat the market, it is more likely to happen in the small-cap stock sector. • This poses a good opportunity to study the validity of the Efficient Market Hypothesis. • Mis-valuation of small-cap stock mutual fund shares (a.k.a. predictability of small-cap stock mutual fund return): Chalmers, Edelen, and Kedlec (JF 2002) On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

7. What is Liquidity? Source: http://www.cartoonstock.com/directory/l/liquidity.asp On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

8. Stock Liquidity • Information cost: A liquidity trader loses to an information trader. (Kyle (1985)) • Trading cost: Liquidity demander has to pay a price to liquidity supplier in the form of higher bid-ask spread or adverse price impact. • For small-cap stocks • There are less buyers and sellers and more private information in the market. • As a result, the dealers usually pose a higher bid-ask spread. • It is harder to buy or sell a large number of shares of small-cap stocks at fair price relative to large-cap stocks. On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

9. Daily Stock Liquidity Measurement • Bid-ask spread • Standardized bid-ask spread • Turnover • Standardized turnover*** On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

10. Daily Small-Cap Stock Liquidity: 2002-2008 On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

11. Stock Liquidity and Stock Return • Cross-sectionally, more illiquid stocks earn a higher return. (Amihud and Mendelson (1986), Glosten and Harris (1988), Brennan and Subrahmanyam (1996), Amihud (2002), Pastor and Stambaugh (2003)) • On a time-series basis, expected market illiquidity positively affects ex ante stock excess return. (Amihud (2002)) On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

12. Mutual Fund Asset Liquidity • High correlation between asset liquidity and fund share restrictions (a determinant of shares liquidity) in mutual funds and hedge funds (Chordia (1996), Ding, Getmansky, Liang and Wermers (2008)) • This paper only looks at asset liquidity • Measurements of fund liquidity: • Holdings-based liquidity measures: Value-weighted stockholdings’ liquidity measures • Net return-based liquidity measures: First-order daily return autocorrelation (related to share mispricing) • Liquidity risk of Hedge funds • Aragon (2006) (fund restrictions causing shares illiquidity) • Sadka (2008) (asset liquidity factors) On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

13. Figure 1 Fund Liquidity over 2003-2007 On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

14. Fund Liquidity Management and Trading Activity • Mutual funds make informed trades if it’s driven by valuation information and uninformed trades if driven by response to flows. (spillover from investor-induced liquidity.) (Grinblatt and Titman (1993), Wermers (2000), Coval and Stafford (2007), Alexander, Cici, and Gibson (2007)) • Portfolio turnover was regarded as an indicator of activeness of portfolio management and positively related to portfolio performance. • However, too much trading would lead to higher trading costs, thus eroding returns. This is especially true for small-cap funds. • Thus it isn’t clear what is the optimal trading behavior of small-cap fund managers from liquidity point of view. On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

15. Literature Review • Yan (2006) finds that the negative relation between fund size and return is stronger when funds hold illiquid assets. • Comerton-Forde, Gallagher, Nahhas, Walter (2006) studies the performance of Australian institutional small-cap funds using monthly holdings and daily trades and find that small-cap managers possess superior stock selection ability. • Huang (2008) finds that fund managers tend to tilt their holdings toward liquid stocks in anticipation of volatile market. On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

16. Results Preview • Small-cap funds holding more illiquid stocks earn higher return, even after common risks are accounted for. • Small-cap funds tend to trade liquid stocks (due to less price impact) and hold on to illiquid stocks. • The return of small-cap funds holding more illiquid stocks is more sensitive to stock market liquidity. On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

17. The Sample • Source: CRSP survival-bias free mutual fund database • Fund Stockholdings (2003Q1 – 2007Q4) • Fund daily returns (1998/9/2 – 2007/12/31) • CRSP daily stock files • Sample period: 2003/4-2007/12 • 1,047 small-cap funds; 429 Porftolios • Lipper objective codes: SCCE (Small-Cap Core), SCGE (Small-Cap Growth), SCVE (Small-Cap Value) • Must have holdings information • Number of stockholdings less than 1,000 (to exclude the small-cap index funds) • 7,343 small-cap stocks held by small-cap funds On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

18. Methodology: U.S. Small-Cap Stock Mutual Fund Performance • Jensen’s alpha using a small-cap index as the market portfolio • Fama-French three-factor alpha • Fama-French/Carhart four-factor alpha • Small-cap stock indices are downloaded from Yahoo!Finance: http://finance.yahoo.com/q?s=^RUT (Russell 2000 Index)http://finance.yahoo.com/q?s=^RUJ (Russell 2000 Value Index)http://finance.yahoo.com/q?s=^RUO (Russell 2000 Growth Index) • Factor data are downloaded from Prof. Ken French’s web site: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

19. Table I: Summary Statistics On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

20. Table II: U.S. Small-Cap Mutual Fund Performance On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

21. Table III Liquidity-Performance Relation for U.S. Small-Cap Equity Mutual Funds On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

22. Table IV Panel A: Average Daily Returns of Small-Cap Funds Sorted by Liquidity Measure On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

23. Table IV Panel B: Regressions of Funds Sorted by Liquidity Measure On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

24. Table V: Liquidity Characteristics of Stocks Traded by U.S. Small-Cap Equity Mutual Funds On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

25. Figure 2(a): Quarterly Average Daily Return of Stocks Traded by U.S. Small-Cap Core Mutual Funds On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

26. Figure 2(b): Quarterly Average Daily Returnof Stocks Traded by U.S. Small-Cap Growth Mutual Funds On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

27. Figure 2(c): Quarterly Average Daily Returnof Stocks Traded by U.S. Small-Cap Value Mutual Funds On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds

28. Conclusions • Liquidity is a determinant of U.S. small-cap mutual fund performance. • Funds holding more illiquid stocks tend to perform better, even after market risk is accounted for. • Liquidity affects U.S. small-cap growth funds and small-cap value funds differently. • For value funds, high-liquidity funds perform better than low-liquidity funds after the market risk and fund liquidity are accounted for. • For growth funds, liquidity can explain away the performance differential between the high-liquidity and low-liquidity funds. • Small-cap funds tend to sell high-liquidity stocks and buy lower-liquidity stocks, but hold on to most illiquid stocks. On the Liquidity and Performance of U.S. Small-Cap Equity Mutual Funds