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

Xi Dong, Namho Kang and Joel Peress

The Review of Financial Studies, 2025, vol. 38, issue 10, 2936-2987

Abstract: We document that persistent aggregate capital flows to hedge and mutual funds predict monthly factor returns with an out-of-sample R2 reaching 6.6%. Transient flows display no such power despite being more predictable. We 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, capital flows into factor trading strategies, leading to factor-return predictability and factor momentum, yet greater price efficiency. Our key insight is that capital-constrained managers account for both current and anticipated future flows in the arbitrage sector, thereby incorporating the dynamics of capital into their strategies.

Date: 2025
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