Aurora Borealis
1 April 2016 CFA Institute Journal Review

Mandatory Portfolio Disclosure, Stock Liquidity, and Mutual Fund Performance (Digest Summary)

  1. Vassilis Efthymiou, CFA

After the US SEC made quarterly disclosure of mutual fund holdings mandatory, liquidity in stocks more heavily held by mutual funds increased considerably. But these mutual funds suffered from significant deterioration of profitability as a result of disclosing their selections of stocks made on the basis of an assumed informational advantage.

What’s Inside?

The authors investigate the interplay between frequent disclosures of stock holdings by equity mutual funds, liquidity of the stocks the funds invest in, and mutual fund performance. To perform such a test, they take advantage of a change in US SEC regulation in May 2004, when the frequency of submission of filings of mutual fund holdings became quarterly instead of semi-annual. They find that increasing the frequency of mandatory portfolio disclosure of stocks held by mutual funds leads to increased liquidity in the stocks, especially when they have been characterized by high information asymmetry among investors and traders in the past. Moreover, the profitability of mutual funds declines significantly following this change in SEC rules, especially mutual funds in the best-performing fund category on the basis of their risk-adjusted return history and those concentrating in stocks with high information asymmetry. As investment signals from disclosed mutual fund holdings are conveyed to other market participants more often, the acceleration of trading in these stocks will eliminate any assumed mispricing opportunity in the stocks at a faster pace.

How Is This Research Useful to Practitioners?

The impact of the requirement of quarterly reporting of mutual fund holdings to the SEC differs for different groups of investors. It is considered negative for professional portfolio managers of equity mutual funds because they have to make known their stock portfolio selections on a quarterly basis, which entails sharing their investment ideas with the public, possibly before they are able to take full advantage of the stock’s expected outperformance. As a result, portfolio managers may be less likely to invest in stocks whose price deviates from fair value, but it takes longer than a full quarter for the mispricing to correct in the market. To dampen the negative effects on mutual fund performance, the SEC allows a 60-day delay from the close of the quarter as the maximum-length period for mutual fund managers to submit their filings. This delay helps neutralize front running and “mimicking” of mutual fund structure.

Enhanced liquidity for stocks in which mutual funds initiated or increased their holding, however, constitutes an advantage for all market participants because it reduces the transaction costs of such stocks. The reduction in spreads and overall transaction cost is especially important for individual investors who cannot benefit from the economies of scale associated with institutional investors that have the capacity to transact in large trade volumes.

How Did the Authors Conduct This Research?

The authors use a sample of 1,459 actively managed US equity mutual funds, which are bound by the SEC’s requirement of a quarterly frequency of ownership disclosure after May 2004. Moreover, for the purpose of control samples, they use index funds and hedge funds with respective equity investment focus that do not fall under the SEC’s regulatory framework. The relationship between disclosure frequency and stock liquidity is tested using a difference-in-differences regression, according to which the hypothesized increase in liquidity after May 2004 for stocks mainly owned by mutual funds is tested against the possibility of liquidity being higher altogether for equities, even for those with low ownership by mutual funds. Likewise, regarding the relationship between disclosure frequency and mutual fund performance, there is a significant deterioration of fund profitability following the regulatory change, and it is worse in funds that concentrate their holdings in stocks with high information asymmetry or funds that take longer to unwind the positions that have lost their relative valuation advantage because of the SEC disclosure.

Empirical results are tested for robustness with several alternatives for estimation specifications, independent variables, and control samples: (1) placebo tests run on funds that are voluntarily—as opposed to mandatorily—disclosing holdings; (2) placebo tests run on different periods to address the possibility that significant results may be the result of trends or mean reversion on stock liquidity or mutual fund performance over time; (3) such different measures of stock liquidity as the Amihud metric, size-weighted spread, effective spread, and so forth; and (4) such different measures of fund profitability as the four-factor alpha, five-factor alpha, DGTW-adjusted return, and so forth. In all cases, the estimated regression coefficients are significant and indicate that the higher frequency of portfolio holdings disclosure is positively associated with stock liquidity but negatively associated with mutual fund performance.

Abstractor’s Viewpoint

Altogether, the authors’ findings suggest that although the increase in disclosure frequency may enhance the liquidity and reduce the transaction cost for stocks that are found to constitute a significant part of a mutual fund’s portfolio, the very same regulatory change may result in the previously best-performing mutual fund managers earning average returns. Ultimately, the conclusion of which of the two is more desirable for traders and investors rests with the regulator and competent bodies in representation of the investment management profession.

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