Correlated Flows, Portfolio Similarity and Mutual Fund Liquidity Management

Abstract

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. The benefit of Overlap Management is therefore distinct from that of strategy uniqueness as studied in prior literature. An examination of the channel through which Overlap Management contributes to fund performance suggests that overlap management effectively alleviates the negative feedback effect of outflows on future performance.

Keywords: Liquidity Shocks, Portfolio Overlap, Mutual Fund Performance

JEL Classification: G11, G23, G30