Liquidity Dry-ups in equity markets

Abstract

This paper examines how mutual fund investors’ demand for liquidity provision endogenously affects stock liquidity in the equity market. We find that actively managed funds in the US tend to hold less liquidity than their respective benchmarks, which leads them to rely on only a small fraction of liquid stocks when it comes to liquidity demand. Using mutual fund sell transactions, we further show that mutual funds tend to sell more liquid stocks in their holdings when experiencing outflows. Concentrated sales of liquid stocks, however, significantly reduce the liquidity of these stocks, resulting in liquidity deterioration or dry-up among highly liquid stocks in periods of high market-wide liquidity demand. Overall, the results indicate that mutual funds fail to predict the liquidity of the asset at purchase. © 2023 Elsevier Inc.