Fragile Liquidity: Analysis of the Mutual Fund Liquidity Risk Management Rule

Abstract

I study unintended consequences of the Liquidity Risk Management Rule adopted by the SEC in 2016. The rule imposes an upper bound for illiquid assets and a lower bound for liquid assets in mutual fund portfolios. In response to the regulation, corporate bond mutual funds shift their portfolios toward liquid corporate bonds. The ownership shift to liquid corporate bonds decreases the performance of funds and increases the comovement among the underlying liquid assets. Higher comovement among liquid corporate bonds increases the volatility in liquid corporate bond funds. However, I find little evidence of stabilized fund flows. Overall, reducing fragility in mutual funds using portfolio constraints has unintended consequences.

Keywords: mutual funds, corporate bonds, liquidity management, return comovement

JEL Classification: G11, G18, G23, G28