Paper: arXiv 2405.12768

Abstract

Many active funds hold concentrated portfolios. Flow-driven trading in these securities causes price pressure, which pushes up the funds’ existing positions resulting in realized returns. We decompose fund returns into a price pressure (self-inflated) and a fundamental component and show that when allocating capital across funds, investors are unable to identify whether realized returns are self-inflated or fundamental. Because investors chase self-inflated fund returns at a high frequency, even short-lived impact meaningfully affects fund flows at longer time scales. The combination of price impact and return chasing causes an endogenous feedback loop and a reallocation of wealth to early fund investors, which unravels once the price pressure reverts. We find that flows chasing self-inflated returns predict bubbles in ETFs and their subsequent crashes, and lead to a daily wealth reallocation of 500 Million from ETFs alone. We provide a simple regulatory reporting measure – fund illiquidity – which captures a fund’s potential for self-inflated returns.

Complexity vs Empirical Score

  • Math Complexity: 4.0/10
  • Empirical Rigor: 8.5/10
  • Quadrant: Street Traders — practical and empirical, lighter on theory

Why this score: The paper relies on robust empirical analysis with detailed data on fund flows and portfolio holdings, and provides a concrete regulatory measure, but the mathematical models are relatively straightforward decompositions without heavy derivations.

Research Flowchart

  flowchart TD
  A["Research Goal: Decompose fund returns into price pressure vs. fundamental value"] --> B["Methodology"]
  B --> C{"Key Inputs"}
  C --> D["Fund Holdings & Returns Data"]
  C --> E["ETF Flow Data"]
  B --> F["Computational Process: Decomposition & Feedback Loop Analysis"]
  D & E --> F
  F --> G["Key Findings/Outcomes"]
  G --> H["Price Pressure Effect: Self-inflated returns drive flows"]
  G --> I["Feedback Loop: Return chasing creates bubble/crash cycles"]
  G --> J["Wealth Reallocation: $500M daily shift from ETFs"]