How Does Illiquidity Affect Delegated Portfolio Choice?

Abstract:     
In a continuous-time dynamic portfolio choice framework, I study the problem of an investor who exogenously decides to delegate the administration of her savings to a risk-averse money manager who trades multiple risky assets in a thin market. I consider a manager who is rewarded for increasing the value of assets under management, which is the product of both the manager's portfolio allocation decisions, taken over the investment period, and the money flows into and out of the fund, as a result of the portfolio performance relative to an exogenous benchmark. The model proposed here shows that, whenever the manager can substitute between more illiquid and less illiquid risky assets, she is likely to choose to hold an initial portfolio that is skewed toward more illiquid assets, and to gradually shift toward less illiquid assets over the investment period. The model further shows that, several misalignments of objectives between the investor and the manager can lead to large utility costs on the part of the investor, and that these costs decrease with asset illiquidity. Solving for the shadow costs of illiquidity, the model indicates that delegated rather than direct investing is likely to lead to larger price discounts.

Number of Pages in PDF File: 45

Keywords: Illiquidity, Portfolio Delegation, Benchmarking

JEL Classification: G11, G12, D60, D81

working papers series