Flow-induced Trades and Asset Pricing Factors

Abstract

We show that mutual funds’ flow-induced trades significantly influence returns and comovement among 50 well-known asset pricing factors (anomalies). Mutual fund investors are ignorant about both systematic and idiosyncratic risks when allocating capital among funds. We measure the non-fundamental demand shocks to each factor by aggregating mutual funds’ flow-induced trading of individual stocks underlying the factor. We show that flow-induced demand shifts largely determine factor return dynamics and that the expected (co)variance of flow-induced trades of factors strongly forecasts factor return (co)variance. Our results indicate that these factors are heavily exposed to flow-driven “noise trader” risk, which we further show is significantly priced. The flow-driven effects on factor return dynamics can partially explain factor momentum and underperformance of large-sized mutual funds relative to small funds.