Essay One: Does Stock Volatility Reveal Mutual Fund Manager Skill?...[ Read more ]

Essay One: Does Stock Volatility Reveal Mutual Fund Manager Skill?

If some mutual fund managers have the ability to outperform benchmarks on a risk-adjusted basis, then a natural question to ask is where they should concentrate their efforts. Stocks that display high volatility relative to the benchmark may occasionally offer greater opportunities to investors who are better informed about fundamental values than the market. As a result, skilled investors may end up assigning greater weights on stocks with high idiosyncratic volatility and, in consequence, the volatility of the stocks in an investor’s portfolio may indicate the investor’s degree of skill. I examine the stock portfolios of mutual funds and find that funds which hold stocks with higher idiosyncratic volatility have higher future returns and higher future inflows on average. In a successful manager’s portfolio, high idiosyncratic volatility stocks outperform the remainder, indicating “skill” is best deployed in stocks with high volatility, and this is not the case for unsuccessful managers.

Essay Two: How does Flow Affect the Liquidity Preferences of Mutual Funds?

Compared with funds experiencing outflows, funds with inflow of money are reducing the liquidity of their portfolios by buying more illiquid stocks and selling more liquid stocks. This negative relationship between fund flows and preferences for liquidity is due to the predicted part of flow—the expected flow and is stronger from the buy side of fund trading. Funds with outflows are increasing portfolio liquidity as a precaution for future withdrawals, and funds experiencing inflows have less redemption pressure in the future, so they tend to invest in illiquid stocks to obtain higher returns. This negative effect of flow on preferences for liquidity is more pronounced in growth funds, funds holding more illiquid stocks, small-cap funds, large funds, funds charging higher expenses, funds with lower turnover ratio, and older funds, and it is stronger when the expected market volatility is higher.