Referee Finance

Home of the Financial Intelligence Lab

  • Increase font size
  • Default font size
  • Decrease font size

Payoff Complementarities and Financial Fragility

E-mail Print PDF

Payoff Complementarities and Financial Fragility: Evidence from Mutual Fund Outflows

Qi Chen, Itay Goldstein, Wei Jiang

Various economic theories link financial fragility to strategic complementarities. There is limited data on the behavior of depositors/speculators in settings that exhibit strategic complementarities. Also theoretical models of financial fragility and strategic complementarities usually have multiple equilibria, and thus do not generate clear empirical predictions.


This empirical study attempts to provide a link between strategic complementarities and financial fragility based on data of mutual funds. This empirical approach using a global game model is based on the idea that strategic complementarities in mutual fund outflows are stronger when the fund’s assets are more illiquid. This is because funds with illiquid assets should experience more costly adjustments to the existing portfolios. This pattern predicted above can be less prominent in funds that are held mostly by institutional investors than in funds that are held mostly by retail investors.

The empirical analysis focuses on 3185 equity funds from the CRSP Mutual Fund database from 1995-2005. CRSP S&P style code and area code is used to identify the types of assets each fund invests in. A regression analysis is performed to estimate the effect of liquidity on the flow –performance sensitivity. The fund flow variable is regressed over monthly average excess returns, control variables of fund size, fund age in log years, fund expense in percentage points, front end and back end load charges and dummy variable for institutional shares.

Overall, the study find that investors’ flows are significantly more sensitive to poor performance for funds that invest in illiquid securities than for funds that invest in liquid securities. These results are first obtained when funds’ liquidity were sorted with a dummy variable, where illiquid funds include funds that invest in small-cap and mid-cap stocks and most funds that invest in equity of a single foreign country.

Further, the liquidity effect on fund outflows is only present in funds that are primarily open to small/retail investors. This is consistent with behavior that is based on payoff complementarities among investors in their redemption decisions. Such behavior contributes to financial fragility of the type highlighted in the bank-run literature. The key to the model is that for the marginal investors who are making the decision at a given point in time, the incentive to redeem is monotonically increasing in the magnitude of redemption by other investors in the same fund. The empirical results are consistent with these predictions.

The study finds that Institutional investors’ redemptions are more sensitive to bad performance in illiquid funds than in liquid funds. Given that outflows are much costlier for illiquid funds, one would expect illiquid funds to take measures to either reduce the amount of outflows or minimize their impact on fund performance. Such measures include setting a redemption fee and holding more cash reserves. Indeed, the study finds that illiquid funds are more likely to take each one of these measures. Of course, these measures can only partially mitigate, but cannot completely eliminate, the damaging effect of self-fulfilling outflows caused by payoff complementarities.

Chen, Qi, Goldstein, Itay and Jiang, Wei, "Payoff Complementarities and Financial Fragility: Evidence from Mutual Fund Outflows" (February 2007). Available at SSRN:



You can follow us on Twitter  @fintlab and facebook