The illiquidity exposure factor: An overlooked driver of mutual fund performance

Abstract: This paper examines if Swedish-focused mutual funds with more illiquid holdings produce higher alpha. By extending the classic Fama and French five-factor model, we pinpoint the effect of illiquidity in underlying holdings on mutual fund alpha generation through a two-step regression model with data between 2019-2022. With share-specific data of price and volume, a daily factor representing share-specific illiquidity is created, matched and weighed with fund holding data to compute the funds’ quarterly average illiquidity exposure factor. We show that this share-specific liquidity risk, or “the illiquidity exposure factor”, has a significant and positive effect on mutual fund alpha, the market-adjusted returns net of costs, indicating that illiquidity in a fund’s underlying shares positively impacts its alpha and should be considered by managers and investors who aim to generate positive risk-adjusted return that is uncorrelated with the market. Furthermore, based on these findings, we propose that the share-specific illiquidity exposure factor should be more widely used as a future variable within financial research that aims to evaluate fund performance and managerial skill.