Winston Wei Dou

Common Fund Flows: Flow Hedging and Factor Pricing

Joint with Leonid Kogan, Wei Wu

February 2020

We consider an economy populated by myopic investors, in which some investors are natural clientele of professional active fund managers and delegate their investment decisions. 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 endogenously respond to aggregate economic shocks, 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 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 breakout 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 hedging motives.