Network externalities in mutual funds

The literature on mutual fund flows documents surprisingly large return effects given that mutual fund flows are uninformed (i.e., not related to fundamentals). I provide evidence that network externalities generate the necessary amplification mechanism to support these results. Network externalities are generated by mutual funds with common holdings and return-chasing investors. Economically, I show that the fund flow network externality is 32–92% as large as the typical explanatory effects (e.g., lagged flows). Network externalities generate a 1.5% quarterly excess return that reverses in the subsequent year, and are independent of style investing and robust to multiple specifications of holdings similarity.