Small-cap equity mutual fund managers as liquidity providers

This paper examines the relation between the performance of small-cap equity mutual funds and the liquidity characteristics of their asset holdings. We study the trading behavior of fund managers and show that on average, they tend to buy less liquid stocks and sell more liquid stocks. We introduce the notion of net “liquidity creation” by fund managers and examine its role in explaining the cross section of small-cap equity mutual fund returns. Our empirical results show that on average, small-cap mutual fund managers are able to earn an additional 1.5% return per year as compensation for providing such liquidity services to the market.