Cash Holdings and Mutual Fund Performance*

Abstract

Cash holdings of equity mutual funds impose a drag on fund performance but also allow managers to make quick investments in attractive stocks and satisfy outflows without costly fire sales. This article shows that actively managed equity funds with high abnormal cash—that is, with cash holdings in excess of the level predicted by fund attributes—outperform their low abnormal cash peers by over 2% per year. Managers carrying high abnormal cash compensate for the low return on cash by making superior stock selection decisions, whereas less capable managers find abnormal cash costly and remain more fully invested in equities. Managers of high abnormal cash funds also proficiently satisfy fund outflows and control fund transaction costs, whereas low abnormal cash funds lack flexibility to cover outflows and can suffer from costly fire sales. The empirical evidence suggests that managers carrying abnormal cash benefit from the flexibility it provides despite the costs of holding cash.