Fast and Slow Arbitrage: The Predictive Power of (Persistent) Capital Flows for Factor Returns

The authors document that persistent aggregate capital flows to hedge and mutual funds predict monthly factor returns with an out-of-sample R 2 reaching 6.6%. Transient flows display no such power despite being more predictable. They show - both empirically and theoretically - that persistent flows’ predictive power stems from active fund managers’ capital constraints. As a result, managers invest persistent but not transient flows into factor trading strategies, leading to factor-return predictability and factor momentum yet greater price efficiency. The authors' key insight is that capital-constrained managers account for both current and anticipated future flows in the arbitrage sector, incorporating the dynamics of capital into their strategies.