Correlated Flows, Portfolio Similarity and Mutual Fund Liquidity Management
61 Pages Posted: 7 Nov 2017
Date Written: October 31, 2017
We contend that the confluence of portfolio similarity and correlated liquidity shocks within mutual fund styles can exacerbate fund exposure to liquidity risk. We find that mutual funds mitigate such liquidity risk exposure by systematically reducing portfolio overlap with peer funds when their flows become more correlated (Overlap Management). Overlap Management is highly persistent and is more pronounced among funds with liquidity concerns. Funds engaging in overlap management tend to avoid stocks that are more vulnerable to flow-driven trading when facing correlated flows. As a result, this type of liquidity management independently contributes to higher fund performance after controlling for the direct relation between portfolio overlap and fund performance. Further analyses suggest that the performance consequences of Overlap Management appear related to the weakened feedback effect of past outflows on fund performance. The benefit of Overlap Management is distinct from that of strategy uniqueness as studied in prior literature.
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