Why Do Mutual Funds Hold Cash?

Abstract

We examine the role of cash in a parsimonious model of active portfolio management with performance-driven capital flows and transaction costs. We argue that redemptions following bad performance pose no dilution risk to remaining investors and what appears to be liquidity management by mutual funds is managers collecting rent. Bad performance is a negative signal about a manager and reduces the optimal fund size. Liquidations of illiquid assets to satisfy performance-driven redemptions are efficient and do not justify regulatory interventions. Accommodating redemptions with cash only, as managers with performance-sensitive compensation do, amplifies outflows and destabilizes the fund.

Keywords: Mutual Fund, Performance, Liquidity Management, SEC Rule 22e-4

JEL Classification: D86, G23