Cash holdings of equity mutual funds impose a drag on fund performance but also allow managers to make quick investments in attractive stocks and satisfy outflows without costly fire sales. This article shows that actively managed equity funds with high abnormal cash—that is, with cash holdings in excess of the level predicted by fund attributes—outperform their low abnormal cash peers by over 2% per year. Managers carrying high abnormal cash compensate for the low return on cash by making superior stock selection decisions, whereas less capable managers find abnormal cash costly and remain more fully invested in equities. Managers of high abnormal cash funds also proficiently satisfy fund outflows and control fund transaction costs, whereas low abnormal cash funds lack flexibility to cover outflows and can suffer from costly fire sales. The empirical evidence suggests that managers carrying abnormal cash benefit from the flexibility it provides despite the costs of holding cash.

Levered noise occurs when no-arbitrage replication hedges fundamentals but amplifies price errors. Motivated by our theory, we use widely-available end-of-day OptionMetrics data to improve accuracy of synthetic dividend strip prices and provide longer samples than prior studies. Term structure point estimates are approximately flat in simple returns (88 bp/month vs. 87 bp/month for short-term dividends vs. index), and upward-sloping in measurement-error-robust logarithmic returns (43 bp/month vs. 77 bp/month). These results from prominent index options show the importance of diagnosing noise in no-arbitrage prices. Prior conclusions of an average downward slope in the equity term structure are not robust.