Skip to main content Accessibility help

How Does Illiquidity Affect Delegated Portfolio Choice?

  • Min Dai, Luis Goncalves-Pinto and Jing Xu

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.

Corresponding author
*Dai,, National University of Singapore (NUS) and NUS Suzhou Research Institute; Goncalves-Pinto (corresponding author),, Chinese University of Hong Kong; and Xu,, Renmin University of China.
Hide All

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.

Hide All
Almazan, A.; Brown, K. C.; Carlson, M.; and Chapman, D. A.. “Why Constrain Your Mutual-Fund Manager?Journal of Financial Economics, 73 (2004), 289321.
Ang, A.; Papanikolaou, D.; and Westerfield, M.. “Portfolio Choice with Illiquid Assets.” Management Science, 60 (2014), 27372761.
Basak, S.; Pavlova, A.; and Shapiro, A.. “Optimal Asset Allocation and Risk Shifting in Money Management.” Review of Financial Studies, 20 (2007), 15831621.
Basak, S.; Pavlova, A.; and Shapiro, A.. “Offsetting the Implicit Incentives: Benefits of Benchmarking in Money Management.” Journal of Banking and Finance, 32 (2008), 18821993.
Boguth, O., and Simutin, M.. “Leverage Constraints and Asset Prices: Insights from Mutual Fund Risk Taking.” Journal of Financial Economics, 127 (2018), 325341.
Brown, K. C.; Harlow, W. V.; and Starks, L. T.. “Of Tournaments and Temptations: An Analysis of Managerial Incentives in the Mutual Fund Industry.” Journal of Finance, 51 (1996), 85110.
Busse, J.Another Look at Mutual Fund Tournaments.” Journal of Financial and Quantitative Analysis, 36 (2001), 5373.
Chaudhuri, R.; Ivkovic, Z.; and Trzcinka, C.. “Cross-Subsidization in Institutional Asset Management.” Review of Financial Studies, 31 (2018), 638677.
Chen, H.-I., and Pennacchi, G. G.. “Does Prior Performance Affect a Mutual Fund’s Choice of Risk? Theory and Further Empirical Evidence.” Journal of Financial and Quantitative Analysis, 44 (2009), 745775.
Chen, Q.; Goldstein, I.; and Jiang, W.. “Payoff Complementarities and Financial Fragility: Evidence from Mutual Fund Outflows.” Journal of Financial Economics, 97 (2010), 239262.
Chevalier, J., and Ellison, G.. “Risk Taking by Mutual Funds as a Response to Incentives.” Journal of Political Economy, 105 (1997), 11671200.
Constantinides, G. M.Capital Market Equilibrium with Transaction Costs.” Journal of Political Economy, 94 (1986), 842862.
Cremers, M., and Petajisto, A.. “How Active Is Your Fund Manager? A New Measure That Predicts Performance.” Review of Financial Studies, 22 (2009), 33293365.
Del Guercio, D., and Tkac, P. A.. “The Determinants of the Flow of Funds of Managed Portfolios: Mutual Funds versus Pension Funds.” Journal of Financial and Quantitative Analysis, 37 (2002), 523557.
Edmans, A.; Fang, V.; and Zur, E.. “The Effect of Liquidity on Governance.” Review of Financial Studies, 26 (2013), 14431482.
Elton, E. J.; Gruber, M. J.; and Blake, C. R.. “A First Look at the Accuracy of the CRSP Mutual Fund Database and a Comparison of the CRSP and Morningstar Mutual Fund Databases.” Journal of Finance, 56 (2001), 24152430.
Evans, R. B.Mutual Fund Incubation.” Journal of Finance, 65 (2010), 15811611.
Farnsworth, H., and Taylor, J.. “Evidence on the Compensation of Portfolio Managers.” Journal of Financial Research, 29 (2006), 305324.
Gil-Bazo, J., and Ruiz-Verdu, P.. “The Relation between Price and Performance in the Mutual Fund Industry.” Journal of Finance, 64 (2009), 21532183.
Glode, V.Why Mutual Funds Underperform.” Journal of Financial Economics, 99 (2011), 546559.
Goetzmann, W. N., and Peles, N.. “Cognitive Dissonance and Mutual Fund Investors.” Journal of Financial Research, 20 (1997), 145158.
Hasbrouck, J.Trading Costs and Returns for U.S. Equities: Estimating Effective Costs from Daily Data.” Journal of Finance, 64 (2009), 14451477.
Huang, J.; Sialm, C.; and Zhang, H.. “Risk Shifting and Mutual Fund Performance.” Review of Financial Studies, 24 (2011), 25752616.
Huang, J.; Wei, K. D.; and Yan, H.. “Participation Costs and the Sensitivity of Fund Flows to Past Performance.” Journal of Finance, 62 (2007), 12731311.
Kacperczyk, M.; Sialm, C.; and Zheng, L.. “Unobserved Actions of Mutual Funds.” Review of Financial Studies, 21 (2008), 23792416.
Kahl, M.; Liu, J.; and Longstaff, F.. “Paper Millionaires: How Valuable Is Stock to a Stockholder Who Is Restricted from Selling It?Journal of Financial Economics, 67 (2003), 385410.
Kempf, A.; Ruenzi, S.; and Thiele, T.. “Employment Risk, Compensation Incentives, and Managerial Risk Taking: Evidence from the Mutual Fund Industry.” Journal of Financial Economics, 92 (2009), 92108.
Lee, J. H.; Trzcinka, C.; and Venkatesan, S.. “Do Portfolio Manager Contracts Contract Portfolio Management?Journal of Finance, forthcoming (2019).
Longstaff, F. A.Optimal Portfolio Choice and the Valuation of Illiquid Securities.” Review of Financial Studies, 14 (2001), 407431.
Longstaff, F. A.Portfolio Claustrophobia: Asset Pricing in Markets with Illiquid Assets.” American Economic Review, 99 (2009), 11191144.
Lynch, A. W., and Musto, D. K.. “How Investors Interpret Past Fund Returns.” Journal of Finance, 58 (2003), 20332058.
Ma, L.; Tang, Y.; and Gomez, J.-P.. “Portfolio Manager Compensation in the U.S. Mutual Fund Industry.” Journal of Finance, forthcoming (2019).
Nanda, V.; Wang, Z. J.; and Zheng, L.. “Family Values and the Star Phenomenon: Strategies of Mutual Fund Families.” Review of Financial Studies, 17 (2004), 667698.
Petajisto, A.Active Share and Mutual Fund Performance.” Financial Analysts Journal, 69 (2013), 7393.
Reed, A., and Wu, L.. “Racing the Clock: Benchmarking or Tournaments in Mutual Fund Risk-Shifting?” Working Paper, University of North Carolina (2005).
Schwarz, C. G.Mutual Fund Tournaments: The Sorting Bias and New Evidence.” Review of Financial Studies, 25 (2012), 913936.
Sensoy, B. A.Performance Evaluation and Self-Designated Benchmark Indexes in the Mutual Fund Industry.” Journal of Financial Economics, 92 (2009), 2539.
Simutin, M.Cash Holdings and Mutual Fund Performance.” Review of Finance, 14 (2014), 14251464.
Sirri, E. R., and Tufano, P.. “Costly Search and Mutual Fund Flows.” Journal of Finance, 53 (1998), 15891622.
Spiegel, M., and Zhang, H.. “Mutual Fund Risk and Market Share-Adjusted Fund Flows.” Journal of Financial Economics, 108 (2013), 506528.
Wermers, R.Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transaction Costs, and Expenses.” Journal of Finance, 55 (2000), 16551703.
Zheng, L.Is Money Smart? A Study of Mutual Fund Investors’ Fund Selection Ability.” Journal of Finance, 54 (1999), 901933.
Recommend this journal

Email your librarian or administrator to recommend adding this journal to your organisation's collection.

Journal of Financial and Quantitative Analysis
  • ISSN: 0022-1090
  • EISSN: 1756-6916
  • URL: /core/journals/journal-of-financial-and-quantitative-analysis
Please enter your name
Please enter a valid email address
Who would you like to send this to? *


Full text views

Total number of HTML views: 0
Total number of PDF views: 0 *
Loading metrics...

Abstract views

Total abstract views: 0 *
Loading metrics...

* Views captured on Cambridge Core between <date>. This data will be updated every 24 hours.

Usage data cannot currently be displayed