“Liquidity risk management programs (LRMPs) will be a focus area for the Division.”
Mutual fund liquidity management has become increasingly important since the financial crisis of 2007–2009, during which regulators and practitioners raised concerns about whether mutual fund portfolios had enough liquidity to process fund outflows and guard against potential investor runs (i.e., widespread withdrawals). Mutual fund liquidity management has become even more salient since the COVID-19 pandemic. According to Fitch (2020), at least $62 billion worth of mutual funds suspended redemptions in the first half of 2020 due to liquidity mismatch. Therefore, the SEC began focusing on mutual fund liquidity management in 2021.
To date, academic research on mutual fund liquidity management has mainly examined the ways in which mutual funds manage liquidity and subsequent fund performance. However, the impact of mutual fund liquidity management on portfolio firms has not received much attention. To fill this void, in my recent study, “Mutual Fund Liquidity Management, Stock Liquidity, and Corporate Disclosure,” I examine whether mutual fund liquidity management affects portfolio firms’ stock liquidity and information disclosure. I predict that mutual funds will pressure portfolio firms to improve their portfolio liquidity by improving stock liquidity, and one way to improve stock liquidity is to increase disclosure.
In terms of empirical design, identifying the effects of mutual fund liquidity management on portfolio firms’ stock liquidity and corporate disclosure can be difficult. Mutual fund liquidity management is unobservable to outsiders, and endogeneity can be an issue. To overcome these empirical challenges, I exploit an SEC proposal on September 22, 2015 to enhance mutual fund liquidity management as an exogenous shock to mutual fund liquidity management. Furthermore, I employ a difference-in-differences research design. This proposed rule requires each mutual fund to (1) establish a liquidity risk management program, (2) classify the liquidity level of each portfolio asset based on a few factors, such as bid-ask spreads, (3) disclose the liquidity of fund holdings to the public, (4) determine the minimum percentage of liquid holdings, and (5) stop acquiring illiquid assets when illiquid holdings are more than 15% of a fund’s net assets. These proposed requirements can cause an exogenous increase in mutual fund liquidity management.
Consistent with my predictions, I find that mutual fund liquidity management improves stock liquidity of portfolio firms and that enhancing quality of corporate disclosure is one mechanism through which stock liquidity improves. These findings are also consistent with anecdotal evidence. For example, on August 2, 2019, a large investment research and consulting firm for institutional investors, Edison, stated that mutual funds requiring portfolio firms to maintain and promote stock liquidity for mutual fund liquidity management were likely winners. In addition, Edison asserted that an optimal response from portfolio firms when mutual funds demand more stock liquidity for liquidity management is to ensure adequate and fair disclosure to the market.
This paper identifies an important incentive of mutual funds—mutual fund liquidity management—to improve portfolio firms’ stock liquidity and disclosure. Additionally, it is the first to evaluate the SEC rule on regulating mutual fund liquidity and provides evidence for U.S. regulators and regulators in other countries that are considering similar policies. Lastly, this paper provides novel evidence of a spillover effect of the SEC proposal on stock liquidity and corporate disclosure of portfolio firms, which is likely an unintended, yet important, consequence.
Liwei Weng is an Assistant Professor of Accounting at School of Accounting and Finance, The Hong Kong Polytechnic University.
This post is adapted from his paper, “Mutual Fund Liquidity Management, Stock Liquidity, and Corporate Disclosure,” available on SSRN.