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?


We argue that mutual funds might hold liquid assets to collect rents. We propose a parsimonious model of active portfolio management that incorporates trading costs and liquidity management. Following bad performance, managers compensated on total assets under management optimally reduce illiquid and liquid holdings to maximize expected returns. Managers compensated on past performance, on the other hand, accommodate redemptions by depleting liquid assets first. This strategy, however, exaggerates outflows and destabilizes the fund due to lower expected returns. Moreover, using cash for rent collection is preferred to higher management fees as it makes mutual funds less prone to redemption shocks. Overall, we challenge the interpretation of liquid holdings as conclusive evidence for the degree of liquidity transformation that mutual funds provide.

Working Paper