The Cost of Funding Flow Correlation

Abstract

I investigate the economic importance of correlation in mutual fund flows for funds with overlapping portfolio positions. I illustrate theoretically that systematically correlated trading patterns between funds have a negative impact on asset prices and should influence portfolio choice. Theoretically, I show that the expected return from an asset is conditional on the contemporaneous trading pattern of the asset holder, once trading needs are not i.i.d. Finally, I derive a theoretical upper bound of optimal flow correlation and make the conjecture that an optimal equilibrium portfolio outcome exists for any combination of pairwise fund flow correlations. Empirically, I construct a measure of portfolio adjusted flow correlation and find that co-movement in flows can significantly deteriorate fund performance in the long-run, by about 1.4% annually, measured adjusted for style between peer funds with high and low correlation. Finally, I find that around one third of US mutual funds holds non-optimal portfolios as far as dynamic liquidity from correlated trading patterns is concerned.