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How Does Illiquidity Affect Delegated Portfolio Choice?

75 Pages Posted: 16 Feb 2009 Last revised: 28 Sep 2017

Min Dai

National University of Singapore (NUS) - Department of Mathematics

Luis Goncalves-Pinto

Chinese University of Hong Kong - Department of Finance

Jing Xu

National University of Singapore (NUS) - Department of Mathematics

Date Written: September 28, 2017

Abstract

In response to how they are compensated, mutual fund managers who are under-performing by mid-year are likely to increase the risk of their portfolios towards 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.

Keywords: Mutual Funds, Risk Shifting, Portfolio Delegation, Stock Illiquidity

JEL Classification: C61, D11, D91, G11, G12, G23

Suggested Citation

Dai, Min and Goncalves-Pinto, Luis and Xu, Jing, How Does Illiquidity Affect Delegated Portfolio Choice? (September 28, 2017). WFA 2010 Victoria Meetings Paper; EFA 2009 Bergen Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1342876 or http://dx.doi.org/10.2139/ssrn.1342876

Min Dai

National University of Singapore (NUS) - Department of Mathematics ( email )

Singapore

Luis Goncalves-Pinto (Contact Author)

Chinese University of Hong Kong - Department of Finance ( email )

Cheng Yu Tung Building
Shatin
Hong Kong
Hong Kong

Jing Xu

National University of Singapore (NUS) - Department of Mathematics ( email )

10 Kent Ridge Crescent
Singapore, 119260
Singapore

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