The Liquidity Style of Mutual Funds

Recent literature indicates that a liquidity investment style—the process of investing in less liquid stocks—has led to excess returns relative to size and value. The authors examined whether this style, previously documented at the security level, can be uncovered at the mutual fund level. Across a wide range of mutual fund categories, they found that, on average, mutual funds that held less liquid stocks significantly outperformed those that held more liquid stocks.Recent literature indicates that the liquidity investment style—investing in relatively less liquid stocks within the liquid universe of publicly traded stocks—produces risk-adjusted returns that rival or exceed those of the three best-known market anomalies: small minus large, value minus growth, and high minus low momentum. We examined whether this style, previously documented at the security level, can be found at the mutual fund level.Combining data from an individual stock database and a mutual fund holdings database, we were able to build composites of mutual funds based on the weighted-average liquidity of the individual stocks held by the mutual funds. We then studied the performance of the composites.In aggregate and across a wide range of mutual fund categories, we found that, on average, mutual funds that held less liquid stocks significantly outperformed mutual funds that held more liquid stocks (by 2.65% per year over nearly the last 15 years). Using monthly rebalanced mutual fund composites, we found that for each of the 16 groupings in our U.S. equity universe, the lowest-liquidity composite had a superior annual geometric return, annual arithmetic return, standard deviation, Sharpe ratio, annualized alpha versus the category’s composite average, and annualized alpha versus the three Fama–French factors. Surprisingly, the outperformance of the mutual funds that hold less liquid stocks was primarily due to superior performance in down markets. We found similar results in four separate robustness tests based on permutations in the construction of our liquidity-based composites.Overall, we found that the liquidity premium is sufficiently strong to show up in portfolios of managers who are most likely not directly focusing on liquidity.