(1) 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. (2) The researchers decomposes 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. (3) Because investors chase self-inflated fund returns at a high frequency, even short-lived impact meaningfully affects fund flows at longer time scales. (4) 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. (5) The researchers 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. (6) Around 2% of all daily flows and 8-12% of flows in the top decile of illiquid funds can be attributed to “Ponzi flows”. The researcher estimate that every day around $500 Million of investor wealth is reallocated because of the price impact of Ponzi flows.
In active funds investors are unable to identify whether realized returns are self-inflated or fundamental. Here’s how the magic trick works: 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. The mechanism is as follows: Fund managers pick concentrated positions, new money flows in, that money pushes up prices of the fund’s existing holdings, creating impressive returns that attract more money, which pushes prices higher still. As the researchers put it:
Via their own price impact, active funds effectively reallocate capital from late to early investors.
The numbers are staggering. Around 2% of all daily flows and 8-12% of flows in the top decile of illiquid funds can be attributed to Ponzi flows, with around $500 Million of investor wealth reallocated daily because of this price impact. Even more striking: funds with high Ponzi flows experience subsequent drawdowns of over 200%. This isn’t just academic theorizing—flows chasing self-inflated returns predict bubbles in ETFs and their subsequent crashes. The researchers propose a simple fix: a fund illiquidity measure that captures a fund’s potential for self-inflated returns.