30 – L1 29 Open End Funds Holding Cash For Withdrawals V3

Holding cash means that the portfolio cannot make use of all of its assets in the given investment strategy. Also, if many investors wish to redeem their investments at the same time, the fund may need to sell their existing investments to get cash and increase liquidity. These issues may reduce the overall potential return of the fund. To see this, imagine you invested a million dollars into an open-end mutual fund. The fund allocates half of this investments into a portfolio of equities, earning a 10 percent return. The fund keeps the other half of its investments in cash, earning two percent. What do you think will be the total rate of return on your million-dollar investment? Well, first of all, congratulations on having a million dollars to invest. Second of all, you’ll probably guess that your rate of return will be less than the 10 percent return on the portfolio of equities because only half of your money is allocated to it. The return on the fund is a weighted average of the active investments and the cash. In other words, a half of 10 percent is 5. A half of 2 percent is 1. 5 plus 1 is 6 percent. So, the total return of the fund is 6 percent, which is less than the 10 percent return of the equities.

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