A Flow-Based Explanation for Return Predictability

Abstract

This paper proposes and tests an investment-flow based explanation for three empirical findings about return predictability -- the persistence of mutual fund performance, the "smart money" effect, and stock price momentum. Motivated by prior studies, I construct a measure of demand shocks to individual stocks by projecting mutual fund flows onto the stocks they hold, and document a significant flow-induced price pressure effect in individual stock returns. Moreover, building upon prior results that capital flows to mutual funds are highly predictable, I further show that the flow-based mechanism can lead to significant stock return and mutual fund performance predictability. The main findings of the paper are 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.

Keywords: Capital flows, Price pressure, Return predictability, Performance persistence, Smart money effect, Stock price momentum

JEL Classification: G12, G14, G23