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A Flow-Based Explanation for Return Predictability

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  • Dong Lou

Abstract

I propose and test a capital-flow-based explanation for some well-known empirical regularities concerning return predictability--the persistence of mutual fund performance, the "smart money" effect, and stock price momentum. First, I construct a measure of demand shocks to individual stocks by aggregating flow-induced trading across all mutual funds, and document a significant, temporary price impact of such uninformed trading. Next, given that mutual fund flows are highly predictable, I show that the expected part of flow-induced trading positively forecasts stock and mutual fund returns in the following year, which are then reversed in subsequent years. The main findings of the paper are that the flow-driven return effect can fully account for mutual fund performance persistence and the smart money effect, and can partially explain stock price momentum. The Author 2012. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

Suggested Citation

  • Dong Lou, 2012. "A Flow-Based Explanation for Return Predictability," The Review of Financial Studies, Society for Financial Studies, vol. 25(12), pages 3457-3489.
    • Handle: RePEc:oup:rfinst:v:25:y:2012:i:12:p:3457-3489
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    File URL: http://hdl.handle.net/10.1093/rfs/hhs103
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