A Flow-Based Explanation for Return Predictability

doi:10.1093/rfs/hhs103

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A Flow-Based Explanation for Return Predictability

2012-10-08

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Dong Lou *

DOI：10.1093/rfs/hhs103

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Abstract

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I propose and test a capital-flow-based explanation for some well-known empirical regularities concerning return predictability-the persistence of mutual fund performance, the smart money effect, and stock price momentum. First, I construct a measure of demand shocks to individual stocks by aggregating flow-induced trading across all mutual funds, and document a significant, temporary price impact of such uninformed trading. Next, given that mutual fund flows are highly predictable, I show that the expected part of flow-induced trading positively forecasts stock and mutual fund returns in the following year, which are then reversed in subsequent years. The main findings of the paper are that the flow-driven return effect can fully account for mutual fund performance persistence and the smart money effect, and can partially explain stock price momentum.

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