Each Sunday I compose a list containing the most thought-provoking and interesting content I’ve consumed during the past week. Primarily as a way to keep inventory of material that influenced me and my way of thinking.
Papers/Notes
Ponzi Funds (2024) by Philippe van der Beck, Jean-Philippe Bouchaud & Dario Villamaina.
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 selfinflated 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.
The figure shows a strikingly high quantitative resemblance of the thematic ETF’s cumulative price impact and its return. Its raw daily returns and flow-induced trades are over 40% correlated. During this period, the thematic ETF’s positions were 20 times larger than the daily dollar volume in those securities. This implies that whenever the thematic ETF received a 1% inflow on a certain day and proportionally rescaled its positions, it bought 20% of the daily volume in the underlying stocks. Because its portfolio was heavily concentrated in these individual securities and it received over 200% inflows, a large portion of its portfolio return was driven by its own price impact.
The focus of this paper lies on managed funds and the self-inflated feedback loop that arises from the combination of flow-driven trading and the flow-performance relationship. ETFs are a suitable setting to establish first evidence for the interplay of price impact and belief formation because i) we can directly observe demand (via flows) and ii) the proportional reinvestment of flows at a daily frequency allows for cleanly identifying the price impact of non-fundamental demand shocks. However, the underlying drivers of this feedback loop – return chasing and price impact – apply more generally. For example, trend following in futures markets and the $300 Billion wide CTA industry, are likely prone to self-inflated price spirals (see Lemp´eri`ere et al. (2014) and references therein). Similarly, the “quant crunch” in 2007 (Khandani and Lo (2011)) and other deleveraging spirals can be seen as outcomes of the interaction between return chasing and price impact (Brunnermeier and Pedersen (2009); Bouchaud et al. (2012); Cont and Wagalath (2013); Kyle and Obizhaeva (2023)). The increased availability of investor-level holdings and flow data allows quantifying these effects. Revisiting these studies through the lens of portfolio holdings, for example via structural models of investor demand as in Koijen and Yogo (2019), is an exciting avenue for future research. Quite remarkably, our price impact estimate from flow-induced trades matches well the estimates from the recent microstructure literature (e.g. T´oth et al. (2011); Frazzini et al. (2018); Bouchaud et al. (2018)). Bridging the gap between low-frequency portfolio holdings data and trade data at a higher frequency provides an explicit link between market micro-structure, intermediary asset pricing, and (eventually) corporate finance.
Podcasts/Conversations
Kevin Spacey: Power, Controversy, Betrayal, Truth & Love In Film and Life, Lex Fridman Podcast.
How to Build a Future-Proof Portfolio with Bob Elliott & Cem Karsan, Top Traders Unplugged.
Raghuram Rajan, Professor of Finance, Chicago Booth, and Former Head of Reserve Bank of India, Alpha Exchange.
The Zeroes… A Cross Asset Sequel, Alpha Exchange.
Why We Can’t Think Beyond Capitalism – Neoliberalism (Mark Fisher, Capitalist Realism), Philosophize This!
Long vol, short prediction models 