Excess Cash and Mutual Fund Performance

I document a positive relationship between excess cash holdings of actively managed equity mutual funds and future fund performance. The difference in returns of portfolios of high and of low excess cash funds amounts to over 2% annually, or approximately 3% after standard risk adjustment. I study whether this difference in performance can be explained by the differences in managerial stock selection skills, market-timing abilities, fund liquidity needs, and operating costs. I show that managers of high excess cash funds make more profitable stock purchasing decisions, while low excess cash fund managers make better sell decisions. Neither high nor low excess cash groups exhibit significant market-timing skills; however, funds with volatile excess cash holdings are successful market timers. The difference in returns between high and low excess cash groups is particularly pronounced during periods of low fund flows, suggesting that high excess cash funds are better able to anticipate fund outflows. Finally, I show that high excess cash funds incur significantly lower operating expenses than do their low excess cash peers. I additionally document new important determinants of mutual fund cash balances, showing that funds with riskier or less liquid shareholdings, as well as those with higher return gap measures hold more cash. The determinants I consider jointly explain three times more cross-sectional variation in cash positions than variables studied in prior literature. ∗Sauder School of Business, University of British Columbia, 2053 Main Mall, Vancouver, BC, V6T 1Z2. Email: [email protected]. I thank Murray Carlson, Adlai Fisher, Lorenzo Garlappi, Ron Giammarino, Rob Heinkel, and seminar participants at the University of British Columbia for helpful comments. Excess Cash and Mutual Fund Performance