Winston Wei Dou

Common Fund Flows: Flow Hedging and Factor Pricing

Joint with Leonid Kogan, Wei Wu

July 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. Fund managers have hedging motives against fund flow fluctuations, thereby tilting their portfolios toward 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 macroeconomic conditions, and thus a risk premium analogous to the intertemporal hedging term in the ICAPM emerges even in a myopic environment. In the data, we find that fund flows obey a strong factor structure, largely driven by uncertainty, and that shocks to the common fund flows are priced. We also show that fund portfolios are further tilted toward low-flow-beta stocks following exogenous increase in their flow hedging motives, instrumented using the unexpected announcement of the possible US-China trade war and the unexpected occurrences of US natural disasters.