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A flow-based explanation for return predictability

Lou, Dong ORCID: 0000-0002-5623-4338 (2012) A flow-based explanation for return predictability. Review of Financial Studies, 25 (12). pp. 3457-3489. ISSN 0893-9454

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Identification Number: 10.1093/rfs/hhs103


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.

Item Type: Article
Official URL:
Additional Information: © 2012 The Author
Divisions: Financial Markets Group
Subjects: H Social Sciences > HG Finance
H Social Sciences > HB Economic Theory
JEL classification: G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing; Trading volume; Bond Interest Rates
G - Financial Economics > G1 - General Financial Markets > G14 - Information and Market Efficiency; Event Studies
G - Financial Economics > G2 - Financial Institutions and Services > G23 - Pension Funds; Other Private Financial Institutions
Date Deposited: 26 Nov 2012 09:19
Last Modified: 13 Apr 2024 18:15

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