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9 April 2020 CFA Institute Journal Review

How Does Illiquidity Affect Delegated Portfolio Choice? (Summary)

  1. Priyanka Shukla, CFA

This is a summary of "How Does Illiquidity Affect Delegated Portfolio Choice?," by Min Dai, Luis Goncalves-Pinto, and Jing Xu, published in the Journal of Financial and Quantitative Analysis.

Better stock liquidity can improve the risk-shifting incentives of fund managers, likely increasing the costs of delegated portfolio management. When facing portfolio constraints and relative performance benchmarks, fund managers may take on idiosyncratic risk.

What Is the Investment Issue?

In present-day markets, professional asset managers manage an increasing percentage of investors’ financial assets. In the United States, for example, approximately 89% of mutual fund net assets were held by households. This delegated portfolio management relationship presents unique issues because the investors’ incentives may not be well aligned with those of the fund managers.

Here, the authors examine how liquidity and fund constraints in equity mutual funds affect fund managers’ portfolio choices and risks.

Based on their theoretical model, the authors postulate the following:

  • Increased stock liquidity can result in fund managers increasing the size of risky portfolio bets, leading to increased costs of delegation for investors.
  • Given leverage and portfolio constraints, fund managers are likely to make idiosyncratic bets to beat performance benchmarks.

How Did the Authors Conduct This Research?

Following previous research, the authors start by assuming a convex flow-performance relationship, which means that a fund manager has an incentive to take additional risks to attract future fund inflows. While the benchmark is composed of two liquid securities, managers can invest in a risk-free bond, a liquid stock, or a non-benchmark illiquid stock with time-varying liquidity.

The objective is to maximize the fund manager’s expected constant relative risk aversion equity based on the assets under management. The authors evaluate the theoretical model using numerical analysis. The investor’s utility cost is measured using the certainty equivalent rate of return.

Next, the authors conduct an empirical analysis using linear probability models and regression analysis with a sample of US domestic actively managed equity funds. They apply portfolio constraints (such as leverage constraints) and use the decimalization of stocks in 2001 as an exogenous liquidity-enhancing event. The authors calculate tracking error volatilities as a proxy for risk shifting and conduct various control tests to validate the robustness of their results.

What Are the Findings and Implications for Investors and Investment Professionals?

  • Tracking error volatility for mutual funds was 10% more likely to increase between the first and second half of the year, during the liquidity-increasing decimalization event.
  • Risk shifting by fund managers is predominantly idiosyncratic around the decimalization event.
  • Because risk shifters did not have a higher likelihood of beating their benchmark, risk shifting could increase costs for investors.

“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.”

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