What Style Liquidity Timing Skills Do Mutual Fund Managers Possess?

Date01 November 2017
Published date01 November 2017
The Financial Review 52 (2017) 597–626
What Style Liquidity Timing Skills Do
Mutual Fund Managers Possess?
Tarik Bazgour, Laurent Bodson, and Danielle Sougn´
HEC Management School—University of Li`
Recent studies claim that mutual fund managers demonstrate strong MARKET liquidity
timing skills. We extend their liquidity timing tests to the four-factor case and investigate
liquidity timing skills with respect to the MARKET,SIZE, VALUE and MOMENTUM factors.
Contrary to these claims, we find no evidence that fund managers adjust market exposure in
anticipation of market liquidity changes. We find rather strong evidence that fund managers
successfully overweightsmall stocks as market liquidity increases. Our study also demonstrates
that it is easy to misidentify SIZE liquidity timing as MARKET liquidity timing in models that
focus only on MARKET liquidity timing.
Keywords: mutual f unds,aggregate market liquidity, timing skills
JEL Classifications: G11, G23
1. Introduction
This paper is part of the extensive U.S. mutual fund timing literature. “Timing”
can be broadly defined as a tactical asset allocation strategy that successfully adjusts
Correspondingauthor: HEC Management School, University of Li `
ege, rue Louvrex 14 (N1), 4000 Li`
Belgium; Phone: +32 485 475 076; Fax: +32 4 232 72 40; E-mail: tarik.bazgour@ulg.ac.be.
This work was done in collaboration with PwC Luxembourg. We are grateful to PwC Luxembourg for
their financial support. All errors are the sole responsibility of the authors.
C2017 The Eastern Finance Association 597
598 T. Bazgour et al./The Financial Review 52 (2017) 597–626
fund exposure to the market or a certain style of stocks in anticipation of changes in
future market conditions. Much of research in this field has focused on the ability
of fund managers to time market return (e.g., Treynor and Mazuy, 1966; Henriksson
and Merton, 1981; Jagannathan and Korajczyk, 1986; Jiang, 2003), market volatility
(e.g., Busse, 1999) or style returns (e.g., Swinkels and Tjong-A-Tjoe, 2007; Chen,
Adams and Taffler, 2013). More recently, researchers have turned their attention to
investigate whether fund managers time aggregate stock market liquidity (hereafter
simply referred to as market liquidity). Cao, Chen, Liang and Lo (2013) are the first
authors to study this type of timing among hedge fund managers. Their analysis
has since been extended to mutual fund managers in the works of Cao, Simin and
Wang (2013) and Bodson, Cavenaile and Sougn´
e (2013). These authors argue that
since market liquidity is an important state variable affecting stock returns (e.g.,
Amihud, 2002; Pastor and Stambaugh, 2003; Acharya and Pedersen, 2005), savvy
fund managers are, thus, expected to shift money from cash into stocks prior periods
of high liquidity and move from stocks into cash prior periods of lowliquidity. Results
from these tests show strong evidence that fund managers increase (decrease) market
exposure as market liquidity increases (decreases).
In this paper, we revisit this issue of mutual fund liquidity timing. We argue
that the recent studies on this topic suffer from the limitation of focusing exclusively
on market (MKT) liquidity timing: do fund managers adjust market exposure in
anticipation of market liquidity changes? Weclaim, however, that fund managers have
other style liquidity timing opportunities apart from MKT liquidity timing, such as
size (SMB) liquidity timing, growth (HML) liquidity timing, and momentum (MOM)
liquidity timing. In principle, as market liquidity changes, size liquidity timers choose
between small and large stocks; growth liquidity timers adjust exposure along the
value-growth dimension; momentum liquidity timers rotate between contrarian and
momentum strategies. This claim follows the same line of reasoning as Daniel,
Grinblatt, Titman and Wermers (1997) who argue that fund managers can generate
additional performance by tilting their portfolios to certain styles of stocks when they
are the most profitable. Our logic is motivated by the evidence that liquidity risk is
positively related to small stock and momentum returns, and negatively related to
value returns (Pastor and Stambaugh, 2003; Sadka, 2006). We thus expect that fund
managers may also adjust their fund exposure to the style factors in anticipation of
market liquidity changes. Ignoring these style liquidity timing strategies may lead to
false conclusions.
In order to overcome these limitations, this paper extends existing liquidity
timing tests to the four-factor case and investigatesliquidity timing skills with respect
to the MKT, SMB, HML and MOM factors. More specifically, we extend the MKT-
factor liquidity timing model of Cao, Simin and Wang(2013) to a multifactor liquidity
timing framework that accounts for the four style liquidity timing opportunities
available to fund managers. We express fund exposures to all risk factors as linear
functions of market liquidity conditions and apply our extended model to examine the
four style liquidity timing skills using monthly net returns of a sample of U.S. mutual

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