The Value of Cross-Trading to Mutual Fund Families in Illiquid Markets: A Portfolio Choice Approach
Juan M. Sotes-Paladino
University of Melbourne - Department of Finance
National University of Singapore
May 20, 2011
We analyze a liquidity-constrained dynamic asset allocation problem in which investors delegate their portfolios to mutual funds that operate under a family organization. The funds are allowed to cross their trades of illiquid common holdings in response to the interests of the family as a whole, and investors' flows are assumed to reward funds with good past performance disproportionately more than they penalize poorly performing ones. We focus on a previously unexplored channel through which fund families can play favorites among affiliated funds: to have some funds avoid the costs of illiquidity by making others adopt suboptimal investment decisions. We find that families' ability to cross-trade among member funds allows them to save on transaction costs but at the same time elicits higher risk-taking by affiliated fund managers, compared to their standalone counterparts. Moreover, we show that the optimal investment strategies might induce changes in the risk-return profile of the affiliated funds, turning a priori relatively conservative, low return funds, into aggressive, high return ones, and vice versa. We also find that the additional costs of agency that investors incur under a fund family arrangement are likely to increase with asset liquidity. Finally, we show that investors can be better off in general when imposing position limits on their funds' portfolios.
Number of Pages in PDF File: 45
Keywords: Mutual Fund Families, Cross-Trading, Portfolio Delegation, Illiquidity, Portfolio Constraints
JEL Classification: C61, D60, D81, G11, G12, G23
Date posted: March 10, 2010 ; Last revised: March 15, 2012
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