Ebook Mutual fund competition and stock market liquidity
While the finance literature has stressed the role played by the rise of financial intermediation on asset prices, scarce attention has been devoted to the pricing implications of the development of the mutual fund industry and, in particular, to the impact of the competition among mutual fund families on the stock market. This is all the more puzzling as mutual funds provide a very interesting case study to analyze the forces driving financial markets and, in particular, to investigate the determinants of stock liquidity.
This omission is mainly due to the fact that mutual funds have been considered as portfolios of assets and not as products sold by companies competing with each other. The standard theoretical models (Admati and Pfleiderer, 1995) assume away the market structure of the mutual fund industry or assume it to be monopolistic, with no effective competition between mutual fund providers. Mutual funds are identified as ”information collection mechanisms” that provide the service of specialized investment and information collection in return for the payment of fees that compensate for their services (Berk and Green, 2002). An increase in the number of mutual funds should, under these conditions, imply more information collected at equilibrium and greater market liquidity. Indeed, it is a widely held folk theorem that the introduction of mutual funds informationally improves financial markets, reduces stock price volatility and enhances market liquidity. This mantra, that has percolated in the financial press and has shaped the official position of the mutual fund industry, implies a positive relationship between number of funds and information generated.
However, if we move the perspective to the level of the mutual fund family and we assume that fund families jointly choose fees, performance and number of funds, a different view emerges. Competition between mutual fund families distorts the incentives to collect information and induces the fund families to trade-off performance and number of funds. In particular, there is an implicit trade-off between the number of funds that the family sets up and the amount of information that these funds collect. If we allow for free entry in the mutual fund market, an increase in the cost of generating information reduces the amount of information that is provided and the level of the fees that are charged and increases the number of competing funds. Fund proliferation becomes the optimal reaction of the mutual fund family if the cost of information rises, inducing a negative correlation between the number of existing funds and the amount of information that each of them collects in equilibrium.
This provides a new way of looking at one of the most glaring stylized facts in finance: the exponential rise in the number of funds. Mutual funds have experienced an exponential growth in the last two decades. The number of mutual funds in the U.S. has reached 8,171, more than the total number of stocks traded on NYSE and AMEX added together. Over the period 1990-2000 the number of mutual funds grew from 3,081 to 8,171. This growth has almost entirely concentrate in an increase of mutual funds, while the number of fund families has stayed more or less the same (it slightly increased, from 361 to 431). The intuition we propose is that the mutual fund industry, faced either with an increase in the cost of generating information or with a reduction in the cost of setting up new funds, has optimally chosen to reduce the purchase of information and increased the number of funds instead.
This has profound implications in terms of the impact that mutual fund characteristics and competition between fund families have on the stock market. The impact can be defined in terms of information and size. Mutual funds provide a service - portfolio management - whose quality is directly related to their degree of informativeness. At the same time, mutual funds, being in general big players, directly impact the market. The more informed the funds are, the higher the asymmetry with the other traders, the greater the funds’ market impact and the lower the liquidity. Therefore, the amount of information available to the funds is one of the main determinants of market liquidity. Given that information is the very product mutual funds sell, the amount of information - and therefore market liquidity - must be directly related to the way fund families compete with each other and to the fund characteristics such as the price at which they sell it (fees) and the demand they face. This implies that the degree of competition in the mutual fund industry and fund characteristics should be directly linked to stock market liquidity. Not only are informational shocks of the mutual fund managers amplified (reduced) by the fund characteristics, but also exogenously driven changes to these characteristics impact the stock market.
We will provide a model that supports these intuitions and creates the link between information and observable mutual fund characteristics (number of funds, level of fees, degree of informativeness, demand, attitude towards risk). We will then relate these observable fund characteristics to stock characteristics (volatility, liquidity, cross-stock correlations). In particular, we will show how competition within the mutual fund industry generates a trade-off between information and number of funds. If the cost of information rises, less information is collected by each fund and more funds are established. The presence of more and relatively less informed funds affects market makers’s behavior, reducing volatility and increasing liquidity and stock returns.
We will test the empirical restrictions of our approach using the universe of the US equity funds in the past 30 years. We will identify the fund characteristics related to the way the fund families compete with each other, such as the fees they charge, the performance they provide (i.e., the information they collect), their attitude to toward risk, the demand they face, as well as the number of funds themselves. We will then directly relate the return, volatility, liquidity and cross-correlation of the stocks to the characteristics of the mutual funds that are holding them. We will show that the fund characteristics do indeed affect stocks and directly impact returns, volatility, liquidity and cross-stock correlations. Stocks held by funds with analogous characteristics will be more closely correlated. Moreover, these characteristics proxy for ”fund-based” factors that aggregate at the overall market level and seem to be priced.
Our results shed new light on the reason why some stocks co-move more than others and link market liquidity to such a co-movement. This provides a ”rational” explanation to stock behaviors and other anomalies that had, up to now, been explained in behavioral terms.
The paper is structured as follows. In Section 2, we relate to the existing literature and describe our contribution. In Section 3, we lay out the model and in Section 4 we derive the main testable restrictions. In Section 5, we describe the data and the methodology we use. In Section 6, we reports the empirical tests and discuss the findings. A brief conclusion follows.
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