The flows of funds that invest in illiquid assets (dashed line) are less sensitive to returns than funds that invest in liquid assets (solid line).

Why Do Mutual Funds Hold Cash?

Abstract

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.

Publication
Working Paper
Date