Liquidity risk and the performance of UK mutual funds

We examine the role of liquidity risk, both as a stock characteristic as well as systematic liquidity risk, in UK mutual fund performance for the first time. We find that on average UK mutual funds are tilted towards liquid stocks (except for small stock funds as might be expected) but that, counter-intuitively, liquidity rather than illiquidity, as a stock characteristic is positively priced in the cross-section of fund performance. We find that systematic liquidity risk is positively priced in the cross-section of fund performance although controlling for momentum effects weakens the robustness of this finding somewhat. Overall, our results reveal a strong role for stock liquidity level and systematic liquidity risk in fund performance evaluation models.