Portfolio Liquidity and Diversification: Theory and Evidence
49 Pages Posted: 11 Aug 2017
Date Written: August 2017
A portfolio's liquidity depends not only on the liquidity of its holdings but also on its diversification. We propose simple, theoretically motivated measures of portfolio liquidity and diversification. We also develop an equilibrium model relating portfolio liquidity to fund size, expense ratio, and turnover. As the model predicts, mutual funds with less liquid portfolios have smaller size, higher expense ratios, and lower turnover. The model also yields additional predictions that we verify empirically: larger funds are cheaper, funds that trade less are larger and cheaper, and funds that are too big perform worse. We also find that mutual fund portfolios have become more liquid because both components of diversification, coverage and balance, have trended upward.
Keywords: Diversification, Mutual funds, portfolio liquidity
JEL Classification: G11, G23
Suggested Citation: Suggested Citation