Discussion Paper Details

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Title: Portfolio Liquidity and Diversification: Theory and Evidence

Author(s): Lubos Pástor, Robert F. Stambaugh and Lucian Taylor

Publication Date: August 2017

Keyword(s): Diversification, Mutual funds and portfolio liquidity

Programme Area(s): Financial Economics

Abstract: A portfolio's liquidity depends not only on the liquidity of its holdings but also on its diversification. We propose simple, theoretically motivated measures of portfolio liquidity and diversification. We also develop an equilibrium model relating portfolio liquidity to fund size, expense ratio, and turnover. As the model predicts, mutual funds with less liquid portfolios have smaller size, higher expense ratios, and lower turnover. The model also yields additional predictions that we verify empirically: larger funds are cheaper, funds that trade less are larger and cheaper, and funds that are too big perform worse. We also find that mutual fund portfolios have become more liquid because both components of diversification, coverage and balance, have trended upward.

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Bibliographic Reference

Pástor, L, Stambaugh, R and Taylor, L. 2017. 'Portfolio Liquidity and Diversification: Theory and Evidence'. London, Centre for Economic Policy Research.