First-Mover Advantage (Redemptions)

First-mover advantage (redemptions) is the benefit an investor gets by withdrawing money from a fund or similar vehicle before other investors do, when the cost of meeting withdrawals falls on those who stay. It arises when a fund promises daily cash at a stated value but holds assets that take time or a discount to sell. Early leavers are paid in full, while remaining holders absorb trading costs, price falls and a weaker, less liquid portfolio.

The idea explains why open-ended funds and money market funds can suffer runs much like banks, even without deposits. It is a core concern in shadow banking and non-bank financial intermediation. It should not be confused with the business-strategy term "first-mover advantage", which refers to the gains of being first into a new market.

Picture a group of friends who share the cost of a large house. Anyone can leave whenever they like and take back their share in cash, but the house cannot be sold room by room. The first few people to leave are paid from the cash in the kitty. Once that runs out, the rest must sell furniture cheaply to pay later leavers, so whoever stays ends up with less than they put in.

If everyone understands this, the sensible move at the first sign of trouble is to leave early, before the kitty is empty. Each person acting sensibly makes things worse for the group as a whole, and a small worry can turn into a stampede. Rules that make early leavers pay their fair share of the selling cost are meant to take away the reason to rush.

The economic logic was set out for banks by Douglas Diamond and Philip Dybvig in 1983, who showed that a promise of on-demand repayment backed by illiquid assets can produce a self-fulfilling bank run. Funds face a version of the same problem through liquidity mismatch. When a fund sells assets to pay leavers, it typically sells the easiest ones first, leaving those who stay with a harder-to-sell portfolio. Trading costs and price falls caused by the sales are not reflected in the price paid to the investors who leave that day.

Research by Qi Chen, Itay Goldstein and Wei Jiang, published in 2010, found that US equity funds holding illiquid assets saw stronger outflows after poor performance than funds holding liquid assets, consistent with investors anticipating the cost of others' redemptions. The effect is strongest where a fund promises a fixed or stable redemption price, as with funds that aim to keep a constant 1-dollar share value.

• The Reserve Primary Fund, 2008. After Lehman Brothers failed, the fund wrote down its Lehman paper and fell below 1 dollar a share, an event known as breaking the buck. Investors who had already redeemed were paid in full; those who stayed waited for a liquidation.
• Prime money funds, March 2020. Institutional investors pulled large sums from prime funds in the first weeks of the pandemic, adding to strain in commercial paper and other money markets. The possibility of redemption gates under the then rules appears to have encouraged early exits.
• Woodford Equity Income Fund, 2019. The UK fund suspended dealing in June 2019 after heavy withdrawals left it holding a growing share of unlisted and hard-to-sell holdings.

Swing pricing removes much of the advantage by adjusting the price at which investors trade on days of large net flows, so those who cause trading costs pay them. On a day of net redemptions above a set threshold, the fund's price is moved down:

• $P_{\text{swung}}$ is the price paid to redeeming investors that day.
• $\text{NAV}$ is the fund's net asset value per share before adjustment.
• $s$ is the swing factor, the estimated cost of selling assets, as a decimal.

If a fund's NAV is 20 dollars a share and its swing factor is 1.5%, leavers receive $20 \times (1 - 0.015) = 19.70$ dollars a share. The 30 cents kept back per share stays in the fund to cover the cost of the sales, so remaining investors are not diluted. On days of large net inflows the price is moved up instead.

Swing pricing is widely used by funds in Luxembourg, Ireland and the United Kingdom. US open-end funds other than money market funds and exchange-traded funds have been allowed to adopt it under an SEC rule change in 2016, though take-up has been very limited, and a 2022 SEC proposal to make it mandatory was not adopted. For money market funds, the SEC's 2023 reforms instead introduced a mandatory liquidity fee for institutional prime and institutional tax-exempt funds on days when net redemptions exceed 5% of net assets, removed redemption gates, and raised minimum daily and weekly liquid assets to 25% and 50%. Internationally, the Financial Stability Board revised its recommendations on open-ended fund liquidity mismatch in December 2023, alongside IOSCO guidance on anti-dilution tools such as swing pricing, dilution levies and redemption notice periods.

• Financial Stability Board
• US Securities and Exchange Commission
• Faisal Khan: Shadow Banking Explained: How Financial Runs Happen Outside Banks