Common Fund Flows: Flow Hedging and Factor Pricing

Joint with Leonid Kogan, Wei Wu

Journal of Finance Forthcoming, November 2022

Active equity funds care about fund size, affected by fund flows that obey a strong factor structure with the common component responding to macroeconomic shocks. Funds hedge against common-fund-flow shocks by tilting their portfolios toward low-flow-beta stocks, while household/retail and index investors overweight high-flow-beta stocks in equilibrium. Consequently, common-fund-flow shocks earn a risk premium, leading to a multi-factor asset-pricing model like the ICAPM, even with myopic agents and unsophisticated fund clients. Exploiting quasi-experiments induced by the local-natural-disaster occurrences and the unexpected trade-war announcements, we find an increased outflow risk faced by active funds leads to more aggressive flow-hedging portfolio tilts.