A Flow-Based Explanation for Return Predictability

53 Pages Posted: 6 Sep 2009 Last revised: 1 Jul 2010

See all articles by Dong Lou

Dong Lou

London School of Economics & Political Science (LSE); Centre for Economic Policy Research (CEPR)

Date Written: June 30, 2010

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

Suggested Citation

Lou, Dong, A Flow-Based Explanation for Return Predictability (June 30, 2010). Available at SSRN: https://ssrn.com/abstract=1468382 or http://dx.doi.org/10.2139/ssrn.1468382

Dong Lou (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Department of Finance
Houghton Street
London, WC2A 2AE
United Kingdom
+44 (0)207 1075360 (Phone)

HOME PAGE: http://personal.lse.ac.uk/loud/

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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