This study examines the impact the liquidity of a fund’s stockholdings has on the relationship between fund size and performance and finds that liquidity can help explain the performance of a fund. In general terms, liquidity refers to the ability to buy or sell a stock quickly with minimal impact on the overall price of the stock. Within the context of this study, the liquidity of a fund refers to the average liquidity of the individual stocks held in the fund’s portfolio. Previous research that focuses on fund size and performance has yet to clearly determine if investors on average would be better off investing in larger (as measured by total net assets under management) or smaller funds. The author of this study demonstrates that it is not the size of a fund but the interaction of size and liquidity that significantly affects fund performance.

            The author examines the liquidity of the stock holdings of over 1000 actively managed equity funds covering the time period 1993 and 2002 and then focuses on the relationship between the liquidity measures and fund performance. He calculates liquidity on a quarterly basis using the fund’s reported quarterly holdings. There is some debate over the most appropriate measure of liquidity so the author computes two separate liquidity measures. The first measure is based on the average bid ask spread of all stocks held by a fund and is considered to be the most commonly used measure of liquidity. However, this measure is too narrowly defined to capture a manager’s reluctance to trade if a trade is likely to have a large impact on a stock’s price. The author calculates a second liquidity measure that is designed to capture the average size of each individual stock held by a fund relative to that stock’s total market capitalization. If a fund holds a large market share of any individual stock, selling a significant number of shares is likely to have a substantial negative impact on the stock’s price, and thus on the fund’s return. As measured by the second liquidity measure, such a portfolio is considered to be less liquid. 

            The most important result of this study for fund investors is that a significant inverse relationship exists between fund size and performance, and this relationship is driven by liquidity differences across small and large funds. The author sorts all funds into quintiles based on fund portfolio size and also sorts funds into quintiles based on liquidity. Then each fund is placed into a group based on its rank along these two dimensions, and the author calculates the average return of the funds in each group.  The only group with a positive risk adjusted return (as measured by the Carhart model) is the portfolio of the smallest most illiquid funds. When compared to the largest illiquid funds, these small funds outperform the large funds by an average of 35 basis points per month. But when examining the most liquid portfolios, there is no evidence that small funds outperform large funds nor is there any evidence of positive risk adjusted performance. These results hold regardless of the liquidity measure used. The results are also consistent across investment styles although there is some evidence that the relationship is strongest for growth funds (i.e. illiquid growth funds tend to outperform more liquid growth funds). 

Overall, the evidence in this study suggests that investors should focus on smaller less liquid mutual funds as a means of enhancing their portfolio returns.