Liquidity Transformation in Asset Management: Evidence from the Cash Holdings of Mutual Funds
by Sergey Chernenko and Adi Sunderam
Executive Summary — A key function of many financial intermediaries is liquidity transformation: creating liquid claims backed by illiquid assets. To date it has been difficult to measure liquidity transformation for asset managers. The study proposes a novel measure of liquidity transformation: funds’ cash management strategies. The study validates the measure and shows that liquidity transformation by asset managers is highly dependent on the traditional and shadow banking sectors.
We study liquidity transformation in mutual funds using a novel dataset on their cash holdings. To provide investors with claims that are more liquid than the underlying assets, funds engage in substantial liquidity management. Specifically, they hold substantial amounts of cash, which they use to accommodate inflows and outflows rather than transacting in the underlying portfolio assets. This is particularly true for funds with illiquid assets and at times of low market liquidity. We provide evidence suggesting that mutual funds’ cash holdings are not large enough to fully mitigate price impact externalities created by the liquidity transformation they engage in.