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

Abstract

We 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. 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.