Mutual Fund Flight-to-Liquidity

Abstract

This paper examines the liquidity choices of mutual funds during times of market uncertainty. I find that when markets are uncertain, mutual funds actively increase the liquidity of their portfolio-often referred to as a 'flight-to-liquidity.' In aggregate, mutual fund behaviour has implications for the market; the market driven flight-toliquidity places upward pressure on the liquidity premium. I examine the underlying mechanisms driving fund behaviour. I show that market volatility is associated with lower fund performance and withdrawals, which causes funds to adjust the composition of their portfolio towards more liquid assets in order to meet potential redemptions. This causal chain is consistent with Vayanos (2004), who argues that fund managers are investors with time-varying liquidity preferences due to threat of withdrawal. Aggregated over funds, the effect is substantial: a one standard deviation increase in my measure of flight-to-liquidity yields a 0.63 standard deviation increase in the excess return required for holding illiquid securities.

Strategic complementarities and money market fund liquidity management

“…Similarly, consistent with Vayanos' (2004) model, funds increase cash balances when market volatility increases, as this volatility may be associated with investor future redemptions (Huang, 2015;Rzeznik, 2015). Funds also reduce portfolio illiquidity by selling more illiquid stocks during periods of market uncertainty (Ben-Raphael, 2014).…”

“…The literature has found empirical support for both hypotheses in equity funds. Funds that have more illiquid assets have higher cash holdings (Chernenko and Sunderam, 2015;Massa and Phalippou, 2005), and equity funds increase cash after their portfolio liquidity decreases (Rzeznik, 2015). Equity funds that transact more frequently also have higher portfolio liquidity (Massa and Phalippou, 2005).…”