Passive-Aggressive Trading: The Supply and Demand of Liquidity by Mutual Funds

September 20, 2022

Passive-Aggressive Trading: The Supply and Demand of Liquidity by Mutual Funds
Susan K Christoffersen, Donald B Keim, David K Musto, Aleksandra Rzeznik
Review of Finance, Volume 26, Issue 5, September 2022, Pages 1145–1177,

Active mutual fund managers search for profitable investment opportunities and pay for the liquidity required to execute the trades. But what if a fund’s inflows arrive faster than its profitable buying opportunities, or if its redemptions outrun its profitable selling opportunities? These mismatches can cost the fund’s investors by forcing expensive liquidity-demanding trades. But rather than demanding liquidity in such circumstances, the manager can instead tilt toward supplying liquidity for the trades initiated by others, thereby reducing net trade costs for the fund. We test for this strategic substitution between demanding and supplying liquidity by analyzing the changes over time in the cost and performance of active managers’ trades, relating these changes to the changes in both their fund flows and their inventories of trading ideas.

Key to this analysis is our unique database that connects the individual transactions of Canadian mutual funds to their fund flows, as well as other fund- and trade-related characteristics. Through these connections we test whether funds make liquidity-motivated trades when flows outpace trading ideas, and costlier but more profitable liquidity-demanding trades when trading ideas outpace available flows when fund turnover is higher. We also explore the impact of asymmetric information on supplying liquidity by testing whether adverse selection limits the fund’s liquidity provision to the stocks it already owns and for which it has more accurate information.

Our main finding is a large and systematic role for supplying liquidity in active fund management. Funds supply liquidity and pay less for trades when inflows have been higher, when turnover is lower, when trading larger quantities, when they hold more stocks, and when buying stocks they already hold. Tracking these trades forward, the expensive trades perform better than the lower-cost trades. Lower cost and poorer prospects are the distinctive features of liquidity-supplying trades, so we conclude that active funds economize when trade ideas run out by supplying liquidity where they have the latitude and the knowledge.

Finally, we explore the impact of strategic liquidity provision on the overall performance of active funds. Prior research does not find a consistent relation between active fund performance and average trade costs. But if funds pay up only for valuable trades then we should separate buy costs from sell costs, because high buy costs are good news about the similar stocks the fund already holds, and high sell costs are bad news. When we separate buys from sells, this is what we find: fund performance is strongly positive in buy costs, and strongly negative in sell costs.