The Consequences of Fund-level Liquidity Requirements

Abstract

We investigate the effects of mandatory mutual fund liquidity requirements on fund fragility. After the implementation of SEC Rule 22e-4, as required, bond mutual funds hold more liquid securities. However, we find that additional liquidity does not ameliorate fragility. Post-rule, funds with illiquid securities face greater outflows conditional on past underperformance, and fund exits increase. At the holdings level, funds exhibit a higher likelihood of selling illiquid securities post-rule. In turn, such sales increase fund underperformance, thus completing the vicious cycle of fragility. These results are consistent with the theory that fund-level liquidity does not necessarily reduce fund-run incentives. 

Keywords: liquidity requirements, open-end mutual fund, market fragility

JEL Classification: G23, G32, G33, G38