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Informed trading, liquidity provision, and stock selection by mutual funds

Author: Zhi Da; Pengjie Gao; Ravi Jagannathan; National Bureau of Economic Research.
Publisher: Cambridge, Mass. : National Bureau of Economic Research, 2007.
Series: Working paper series (National Bureau of Economic Research), no. 14609.
Edition/Format:   eBook : Document : EnglishView all editions and formats
Summary:
We show that the stock selection ability of a fund manager can be decomposed into two components: "informed trading" and "liquidity provision." As information loses value over time, informed trading tends to be liquidity-absorbing. We conjecture that value enhancing informed trading is more likely in stocks during times when they are associated with more information events. In contrast, liquidity provision is more  Read more...
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Material Type: Document, Internet resource
Document Type: Internet Resource, Computer File
All Authors / Contributors: Zhi Da; Pengjie Gao; Ravi Jagannathan; National Bureau of Economic Research.
OCLC Number: 182559843
Description: 1 online resource (1 volume).
Series Title: Working paper series (National Bureau of Economic Research), no. 14609.
Responsibility: Zhi Da, Pengjie Gao, Ravi Jagannathan.

Abstract:

We show that the stock selection ability of a fund manager can be decomposed into two components: "informed trading" and "liquidity provision." As information loses value over time, informed trading tends to be liquidity-absorbing. We conjecture that value enhancing informed trading is more likely in stocks during times when they are associated with more information events. In contrast, liquidity provision is more likely to add value for stocks associated with few information events and little adverse selection risk. We identify times when there are more information events associated with a stock by its Probability of Informed Trading (PIN, Easley et. al., 1996) measure and information asymmetry component of the spread (Madhavan et. al., 1997). We provide empirical support for our conjecture using quarterly mutual fund holdings data for the period from 1983 to 2004. We find that the informed trading component is relatively more important for mutual funds with a growth oriented investment style whereas liquidity provision is more important for funds with more of an income orientation. Further, the informed trading component of the selection ability of a mutual fund exhibits greater persistence over time.

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