Optimal Allocation in the S&P 600 under Size-Driven Illiquidity
A number of empirical studies have investigated how mutual funds do react to incoming financial resources. As long as liquidity constraints are narrow, fund managers tend to upscale already existing positions without looking for new investment opportunities.
We put forward a model of asset allocation that accounts for market liquidity frictions and recovers the inverse relation between fund size and fund performance. The model prescribes how fund portfolio managers should react as financial resources enter the fund.
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