Dynamic Liquidity Preferences of Mutual Funds

Abstract:     
This paper examines the relation between expected market volatility and the demand for liquidity in open-end mutual funds. Using data on mutual fund holdings and actual trades, I find that mutual fund managers hold more cash and tilt their holdings more heavily toward liquid stocks during periods when expected market volatility is high. Mutual fund managers also actively buy liquid stocks when expected market volatility increases. The dynamic preference for liquidity is more pronounced among two types of funds, namely funds exposed to investor withdrawal risk and funds with superior stock-picking skills. I further show that funds that exhibit dynamic liquidity preferences significantly outperform (both statistically and economically) those that do not exhibit such preferences following periods of high expected volatility.

Number of Pages in PDF File: 67

Keywords: Mutual funds, liquidity, expected volatility, performance, market timing

JEL Classification: G11, G20, G30

working papers series