Defining the liquidity ratio of mutual funds


What is a mutual fund liquidity index?

A mutual fund liquidity index is an index that compares the amount of cash in a fund relative to its total assets. Mutual fund liquidity ratios can vary and may include cash or cash equivalents.

Key takeaways

  • A mutual fund liquidity index is an index that compares the amount of cash in a mutual fund relative to its total assets.
  • Depending on how a specific fund calculates the ratio of a mutual fund, the cash levels may include only cash or also cash equivalents.
  • Mutual funds must find the right balance of cash levels; Too much cash means that money is not invested, which is lost in profitability, while too little cash means that a fund is not liquid enough to cover expenses and unexpected cash needs.
  • Most funds hold approximately 3% to 5% of their total assets in cash.
  • Investors can follow the liquidity ratios of the mutual fund industry to get a sense of the collective perspective of money managers on the market. Liquidity ratios above 5% indicate a bearish outlook, while indices below 5% indicate a bullish outlook.
  • In December 2018, the Securities and Exchange Commission (SEC) began issuing new rules related to managing the liquidity of mutual funds and monitoring the adherence of funds to these rules.

Introduction to mutual funds

Understanding the liquidity ratio of a mutual fund

Mutual funds report a mutual fund liquidity index to provide investors with an idea of ​​how much cash the fund has. Companies can report cash ratios or cash and cash equivalent ratios, which is a broader measure covering cash equivalents that can be easily settled in a short period of time. The ratio is a simple percentage that divides the total cash or total cash and cash equivalents by the total assets of the fund.

Industry speculators are also closely monitoring mutual fund cash levels as an indication of market direction. Most funds hold approximately 3% to 5% of their total assets in cash.

Finding the right cash balance is important to a mutual fund and its investors. Having too much cash on hand – that is, cash that is not invested – is not a useful deployment of investment capital, as it defeats the purpose of investing. Investors provide their cash to mutual funds so that they can be invested and generate a return, most often through capital appreciation, rather than sitting idle.

Having some levels of cash is important as it allows for liquidity. Investments can take time to recover, so doing so to meet cash requirements can be risky if investments are currently at a loss. Therefore, having cash on hand to meet unexpected cash needs or to pay for operating expenses is a prudent measure.

Industry speculation

The Investment Company Institute provides a monthly report on mutual fund industry statistics, which includes information on the average liquidity ratio of mutual funds in the mutual fund industry. In May 2021, the Investment Company Institute reported a liquidity ratio in equity mutual funds of 2.1%.

Generally, investors can follow the liquidity of the mutual fund industry to get an idea of ​​the collective perspective of money managers on the market. Liquidity ratios above 5% are expected to show some fear in the market earnings outlook with a bearish outlook. Liquidity ratios below 5% tend to show that money managers are more bullish on the markets and are fully deploying all cash.

Mutual fund cash regulations

Until 2016, mutual fund cash levels and mutual fund liquidity were not factors that were highly regulated. However, in 2016 the Securities and Exchange Commission (SEC) issued some new rules related to managing the liquidity of mutual funds.

The agency’s new rules went into effect in December 2018, adding some new provisions to the Investment Company Act of 1940. The changes primarily focus on Rule 22e-4, which requires funds to document a comprehensive program of liquidity and invest no more than 15% of their net assets in illiquid investments.

Other changes include amendments to Form N-1A for mutual fund registration, as well as changes to Form N-LIQUID, Form N-CEN, and Form N-PORT. With the new rules, the SEC seeks to help investors buy and redeem stocks more easily, while instituting some new parameters for liquidity risk management and cash position reporting.

www.investopedia.com

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Mark Holland

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