Network externalities in mutual funds

• Amplifying network externalities among mutual funds can explain substantial flow-based effects documented in the literature.
• These network externalities are generated by mutual funds with common holdings and return-chasing investors.
• This externality is 32–92% as large as typical direct effects (i.e. the fund׳s own lagged flows).
• This effect is independent of style investing and robust to multiple specifications of holdings similarity.
• Effects between fund styles provide evidence of crowded trades or ‘style drift’.

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.