Cash versus portfolio liquidation in mutual fund flow management

Determine whether mutual fund managers accommodate investor inflows and outflows primarily by adjusting cash holdings or by liquidating portions of their security portfolios, and characterize the implications of the chosen approach for portfolio-level liquidity and transaction costs in open-ended equity mutual funds.

Background

In the literature on mutual fund liquidity management, two principal mechanisms are discussed for handling investor flows: adjusting cash holdings (building or drawing down cash buffers) and selling or buying slices of the asset portfolio. Each approach has distinct consequences for portfolio liquidity, trading costs, and potential price impact, especially in markets with heterogeneous liquidity.

The paper highlights ambiguity in prior findings: some studies suggest managers sell the most liquid holdings to meet redemptions at lower cost, while other work indicates managers may first liquidate more illiquid holdings to preserve overall fund liquidity, particularly in stressed conditions. This uncertainty motivates empirical investigation into which mechanism is actually employed and under what circumstances.