Why Do Mutual Funds Hold Cash?

Maria Chaderina, Christoph Scheuch

Publication: Working/Discussion PaperWorking Paper/Preprint


We examine the role of cash in a parsimonious model of active portfolio management with performance-driven capital flows and 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 and 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.
Original languageEnglish
Publication statusPublished - 2017

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