The Externalities of Crowded Trades
Vanderbilt University - Finance
March 15, 2013
Vanderbilt Owen Graduate School of Management Research Paper No. 1968488
This paper documents fund flow externalities across mutual funds associated by similar asset holdings. With a network specification of embedded instrumental variables to control for correlated shocks to associated funds, I find that mutual fund managers who ignore these spillover effects may underestimate fund flows by approximately 20%. Peer Flows, (flows to and from other mutual funds funds with similar holdings) account for 2% of mutual fund quarterly return after controlling for various factor models, which is subsequently and completely reversed in the following year. I provide evidence that this overshoot is the result of spillover among connected mutual funds. This effect seems to be the result of crowded trades since similarity is transient, concentrated holdings drive the mutual fund similarity measure, and the initial overshoot lasts only one quarter. Fund similarity may be measurable ahead of time and thus be of interest to fund managers and regulators alike.
Number of Pages in PDF File: 66
Keywords: Mutual Funds, Hedge Funds, Networks, Feedback Loops, Spillover, Contagion
JEL Classification: G12, G20, G14, G18working papers series
Date posted: December 6, 2011 ; Last revised: April 10, 2013
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