Flow-Based Asset Pricing: Two Trading Desk Separation Theorem

Abstract

In any market with uninformative flows, the maximum Sharpe-ratio portfolio can be separated into two. The first portfolio uses only fundamental information to maximize Sharpe ratio. The second portfolio provides liquidity to uninformative flows and maximizes price impact ratio, which is defined as a portfolio's price impact over its fundamental risk. We develop the factor model of price impacts to empirically investigate the maximum-price-impact-ratio (MPIR) portfolio. For U.S. equity mutual fund flows, we find that the MPIR portfolio constructed using flows into Fama and French (1993) factors is a good choice.

Keywords: asset pricing, cross section, flow, price impact, risk

JEL Classification: G12