Common Fund Flows: Flow Hedging and Factor Pricing
62 Pages Posted: 24 Apr 2020 Last revised: 29 Apr 2020
Date Written: April 16, 2020
We consider an economy populated by myopic investors, in which some investors delegate their investment decisions to active fund managers. Managers care about the size of the fund, which fluctuates due to fund returns and fund flows. They have hedging motives against fund flow fluctuations, thereby tilting their portfolios towards stocks with low flow betas. The resulting demand boosts the valuation of low-flow-beta stocks. In equilibrium, fund flows, together with net alphas, endogenously respond to variation in investment opportunity set, and thus risk premium analogous to the hedging term in the ICAPM emerges even in a myopic environment. In the data, we find that fund-level flows obey a strong factor structure, largely driven by macro uncertainty, and that shocks to the common fund flows factor are priced. We also document that fund portfolios are tilted for flow hedging at the expense of losing Sharpe ratio. Particularly, we examine the portfolio choice of mutual funds after the outbreak of the US-China trade war which leads to an exogenous increase in the flow beta of China-related stocks. In such a quasi-natural experiment, we find that active mutual funds rebalance their portfolio holdings of the China-unrelated stocks towards low-flow-beta stocks, consistent with their flow hedging motives. Exploiting the outbreak of US-OPEC oil price war and US natural disasters as additional instruments, we further strengthen our findings.
Keywords: Fund flows, Intermediary asset pricing, Short-termism, Macro uncertainty, Trade war, Oil price war, Natural disaster.
JEL Classification: G11, G12, G23
Suggested Citation: Suggested Citation