Swing Pricing for Mutual Funds: Breaking the Feedback Loop between Fire Sales and Fund Redemptions
Management Science, Forthcoming
47 Pages Posted: 10 Sep 2018 Last revised: 20 Nov 2019
Date Written: March 16, 2019
We develop a model of the feedback between mutual fund outflows and asset illiquidity. Following a market shock, alert investors anticipate the impact on a fund's net asset value (NAV) of other investors' redemptions and exit first at favorable prices. This first-mover advantage may lead to fund failure through a cycle of falling prices and increasing redemptions. Our analysis shows that (i) the first-mover advantage introduces a nonlinear dependence between a market shock and the aggregate impact of redemptions on the fund's NAV; (ii) as a consequence, there is a critical magnitude of the shock beyond which redemptions bring down the fund; (iii) properly designed swing pricing transfers liquidation costs from the fund to redeeming investors and, by removing the nonlinearity stemming from the first-mover advantage, it reduces these costs and prevents fund failure. Achieving these objectives requires a larger swing factor at larger levels of outflows. The swing factor for one fund may also depend on policies followed by other funds.
Keywords: mutual funds, first-mover advantage, swing price, fire sales, financial stability
JEL Classification: G01, G23, G28
Suggested Citation: Suggested Citation