A flow-based explanation for return predictability

Abstract

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. © 2012 The Author 2012. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved.