What Style Liquidity Timing Skills Do Mutual Fund Managers Possess?

• Author: Laurent Bodson,Danielle Sougné,Tarik Bazgour
• DOI: http://doi.org/10.1111/fire.12117
• Date: 01 November 2017
• Published date: 01 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´

e

HEC Management School—University of Li`

ege

Abstract

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`

ege,

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.

C2017 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