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How Does Illiquidity Affect Delegated Portfolio Choice?

  • Min Dai, Luis Goncalves-Pinto and Jing Xu
Abstract

In response to how they are compensated, mutual fund managers who are underperforming by mid-year are likely to increase the risk of their portfolios toward the year-end. We argue that an increase in the liquidity of the stocks that managers use to shift risk can lead to an increase in the size of their risky bets. This in turn hurts fund investors by increasing the costs of misaligned incentives associated with delegated portfolio management. We provide both theoretical and empirical results that are consistent with this argument. We use decimalization as an exogenous shock to liquidity to identify causal effects.

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Corresponding author
*Dai, matdm@nus.edu.sg, National University of Singapore (NUS) and NUS Suzhou Research Institute; Goncalves-Pinto (corresponding author), lgoncalv@cuhk.edu.hk, Chinese University of Hong Kong; and Xu, jing.xu@ruc.edu.cn, Renmin University of China.
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1

For helpful comments, we thank an anonymous referee, Elias Albagli, Daniel Carvalho, Jennifer Conrad (the editor), Michael Gallmeyer, Christopher Jones, Hong Liu, Igor Makarov, Pedro Matos, Salvatore Miglietta, Oguzhan Ozbas, Antonios Sangvinatsos, Breno Schmidt, Joshua Shemesh, Juan Sotes-Paladino, Andreas Stathopoulos, Denitsa Stefanova, Neal Stoughton, Mark Westerfield, Costas Xiouros, and Fernando Zapatero. We also appreciate the comments of participants at the Asian Quantitative Finance Conference, Australasian Finance and Banking Conference, China International Conference in Finance, European Finance Association Annual Meetings, Financial Management Association Doctoral Student Consortium, Individual Finance and Insurance Decisions (IFID) Conference on Retirement Income Analytics, London Business School (LBS) Trans-Atlantic Doctoral Conference, Paris Finance International Meeting, Western Finance Association Annual Meetings, WU Gutmann Center Symposium on Liquidity and Asset Management, and seminar participants at Arizona State University, ESSEC, Hong Kong University of Science and Technology, IESE Business School, Loyola University at Chicago, Nanyang Technological University, National University of Singapore, Purdue University, Singapore Management University, Nova School of Business and Economics, the University of Geneva, the University of Hong Kong, the University of Melbourne, the University of New South Wales, the University of Southern California, the University of Utah, the University of Western Ontario, the University of Amsterdam (UvA), and VU University Amsterdam. Dai gratefully acknowledges financial support from Singapore Ministry of Education (MOE) Academic Research Fund (AcRF) Grant Nos. R-146-000-243-114 and R-703-000-032/201-112, as well as National Natural Science Foundation of China (NSFC) Grant No. 1671292. Goncalves-Pinto gratefully acknowledges financial support from Singapore MOE AcRF Grant No. R-315-000-094-133.

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