Abstract
How to prevent runs on open-end mutual funds? In recent years, markets have observed an innovation that changed the way open-end funds are priced. Alternative pricing rules (known as swing pricing) adjust funds’ net asset values to pass on funds’ trading costs to transacting shareholders. Using unique data on investor transactions in U.K. corporate bond funds, we show that swing pricing eliminates the first-mover advantage arising from the traditional pricing rule and significantly reduces redemptions during stress periods. The positive impact of alternative pricing rules on fund flows reverses in calm periods when costs associated with higher tracking error dominate the pricing effect.
Highlights
Runs on financial institutions pose a significant threat to economic stability and social welfare
Alternative funds are permitted to adjust their net asset value (NAV) to account for trading costs arising from price impact, bid-ask spreads, and other explicit trading costs
Biais and Declerck (2013) document that, outside the crisis periods, effective spreads in European corporate bonds ranged between 12 bps and 22 bps
Summary
Runs on financial institutions pose a significant threat to economic stability and social welfare. We find that funds with traditional pricing rules experience significant outflows during market stress, in line with prior literature (Mitchell, Pedersen, and Pulvino, 2007; Ben-David, Franzoni, and Moussawi, 2011) This effect almost completely reverses for funds that adopt swing pricing, lending support to the view that such rules reduce run risks. Swing pricing, which allows for dilution adjustment on fund NAV, reduces the first-mover advantage arising from the traditional pricing and substantially reduces the outflows during crisis periods In this respect, our findings are consistent with the recent theoretical study of Capponi, Glasserman, and Weber (2018) who show the stabilizing effects of swing pricing. Our paper corroborates their predictions empirically and provides additional cross-sectional and time-series tests of the theory
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