A Flow-Based Explanation for Return Predictability

This paper proposes and tests a flow-based explanation for three important empirical findings on return predictability – the persistence of mutual fund performance, the “smart money” effect, and stock price momentum. Since mutual fund managers generally scale up or down their existing positions in response to investment flows, and since the portfolios of funds receiving capital generally differ from the portfolios of funds losing capital, investment flows can cause significant demand shocks in individual stocks. Meanwhile, since fund flows are predictable from past fund performance and past fund flows, flow-induced price pressure is also predictable. This paper further shows that such flow-based return predictability can fully account for mutual fund performance persistence and the “smart money” effect, and can partially explain stock price momentum. These findings have implications both for asset pricing theories and mutual fund performance evaluation. ∗I am indebted to my advisors Nick Barberis and Will Goetzmann, and to Lauren Cohen, Andrew Metrick, Antti Petajisto, and Paul Tetlock for encouragement and valuable discussions. I also thank Zhiwu Chen, Judy Chevalier, James Choi, Kai Du, Pingyang Gao, Dasol Kim, Stefan Lewellen, Peter Tufano, Jinghua Yan, and seminar participants at Yale and Tykhe Capital for helpful comments. All remaining errors are my own. †P.O. Box 208000, New Haven, CT 06520-8000. Email: [email protected]