Stock returns, mutual fund flows and spillover shocks

• We examine the relationship between stock returns and mutual fund flows in India.
• We apply a generalised VAR model.
• The impact of spillover shocks varies between 5 and 21%.
• Spillover index is found to predict stock returns and mutual fund flows.
• By tracking the spillover index investors in both markets make profits.

In this paper we examine the dynamic relationship between stock returns and mutual fund flows in India by using a generalised VAR model. We find that spillover shocks—that is, stock return shocks and mutual fund flow shocks together explain as much as 20% of the total forecast error variance of stock returns and mutual fund flows. We create a spillover index of shocks emanating from stock returns and mutual fund flows and tests whether it can actually predict stock returns and mutual fund flows. We find it does. Using the spillover index, we forecast stock returns and mutual fund flows, devise trading strategies for a mean–variance investor, and demonstrate the economic significance of the spillover index.