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Going with the Flows

| | Posted in: Momentum Investing, Mutual/Hedge Funds

In their May 2005 paper entitled “Asset Fire Sales (and Purchases) in Equity Markets”, Joshua Coval and Erik Stafford examine the effects on stock prices of mutual funds forced to sell (buy) because of predictable outflows (inflows) of funds based on their past performance. Does such forced selling and buying present predictable opportunities for front-running? By studying mutual fund transactions caused by capital flows from 1980 to 2003, they conclude that:

  • Funds in the bottom decile of capital flows typically hold about 25% fewer securities than the average fund. They are roughly twice as likely to sell, creating significant downward price pressure in the stocks held in common by such funds.
  • Funds with large inflows tend to increase their existing positions, creating significant upward price pressure in the stocks held in common by such funds. Extreme inflows to mutual funds are much more common than extreme outflows.
  • Flow-driven transactions by mutual funds are predictable based on their past performance and their reported holdings. The price effects last about two quarters, taking several more quarters to reverse.
  • Flow-driven buying and selling by mutual funds is highly related to the momentum effect in equity returns. Stocks that mutual funds with poor past performance must sell tend to overlap with the stocks identified as good shorts by a momentum strategy.
  • Investors who provide liquidity by trading against flow-driven transactions earn highly significant returns. An investment strategy that sells short stocks most likely to be involved in forced sales and buys ahead of anticipated forced purchases earns average annual excess returns of over 15%. Most of this excess comes from front-running inflows.

In summary, front-running the predictable effects of unusual mutual fund inflows and outflows on stocks held in common offers significant excess returns.

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