Why Do Mutual Funds Hold Cash?
Type Research Project
Duration Jan. 1, 2017 - Jan. 11, 2018
- Institute for Finance, Banking and Insurance IN (Details)
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We argue that mutual funds hold liquid assets at least partially to collect rents, a motive different from liquidity transformation. We propose a parsimonious model that incorporates the effects of trading costs and liquidity management on fund flows. Following bad performance, managers compensated on fund size optimally reduce illiquid investment to maximize future expected returns, preserving some liquid assets. Managers compensated on past performance, on the other hand, meet redemptions by depleting liquid assets first. However, because of lower expected returns, this only intensifies the outflow and destabilizes the fund. Moreover, the use of cash for rent collection is preferred to higher management fees, as it makes mutual funds less prone to liquidity-driven withdrawals. Overall, we caution not to interpret the observed balances of liquid assets in mutual funds as conclusive evidence of the magnitude of liquidity transformation these funds provide.