Ponzi Funds

TL;DR

This paper analyzes how concentrated active funds' self-inflated returns, driven by flow-induced price pressure, create feedback loops that lead to bubbles and wealth reallocation, highlighting the importance of fund illiquidity as a regulatory measure.

Contribution

It decomposes fund returns into self-inflated and fundamental parts, revealing how return chasing and price impact cause bubbles and suggesting a new measure for fund illiquidity.

Findings

Flow chasing predicts ETF bubbles and crashes.

Daily wealth reallocation from ETFs is approximately 500 million dollars.

Fund illiquidity effectively captures potential for self-inflated returns.

Abstract

Many active funds hold concentrated portfolios. Flow-driven trading in these securities causes price pressure, which pushes up the funds' existing positions resulting in realized returns. We decompose fund returns into a price pressure (self-inflated) and a fundamental component and show that when allocating capital across funds, investors are unable to identify whether realized returns are self-inflated or fundamental. Because investors chase self-inflated fund returns at a high frequency, even short-lived impact meaningfully affects fund flows at longer time scales. The combination of price impact and return chasing causes an endogenous feedback loop and a reallocation of wealth to early fund investors, which unravels once the price pressure reverts. We find that flows chasing self-inflated returns predict bubbles in ETFs and their subsequent crashes, and lead to a daily wealth reallocation of 500 Million from ETFs alone. We provide a simple regulatory reporting measure -- fund illiquidity -- which captures a fund's potential for self-inflated returns.