Why Do Mutual Funds Hold Cash?
54 Pages Posted: 27 Nov 2017 Last revised: 22 Mar 2018
Date Written: March 19, 2018
We examine liquidity risks of mutual funds and the role of liquidity management in a parsimonious model of active portfolio management with 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, it 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
Suggested Citation: Suggested Citation