Can Swing Pricing Prevent Mutual Fund Runs and Failures?

Abstract: We develop a model of the feedback between mutual fund outflows and asset illiquidity. Alert investors anticipate the impact on the fund’s net asset value of other investors’ redemptions and exit first at favorable prices. This self-reinforcing first-mover advantage may lead to fund failure. Our study shows that: (i) the first-mover advantage introduces a nonlinear dependence between an initial price shock and the resulting endogenous asset price change, amplifying the fire sale impact of the initial shock; (ii) because of this amplification, there is a critical shock threshold beyond which a run brings down the fund; (iii) swing pricing not only transfers liquidation costs from the fund to redeeming investors but importantly, by removing the nonlinearity stemming from the first-mover advantage, it reduces these costs and prevents fund failure. (joint work with Marko Weber and Paul Glasserman)