Many active funds hold concentrated portfolios. Flow-driven trading 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.

We study the equity market implications of a reform in the laws that govern trust investments, implemented in a staggered fashion across U.S. states from 1985 to 2006. The introduction of the prudent investor rule systematically alters the relative attractiveness of stocks within the cross-section of U.S. equities for trusts. As trusts account for a substantial fraction of institutional equity holdings in our sample period, and since the reform does not pertain to other investors, our empirical setting provides a rare opportunity to study the impact of a regulatory change on institutional investor holdings and relative prices in the U.S. equity market. We show that, before the reform, trusts tilt their portfolios towards prudent stocks. After the law change, trusts undo these tilts which introduces large and predictable changes in demand. Consistent with a model of inelastic equity markets, we find long-lived outperformance of stocks bought by trusts after the law change relative to stocks sold by those funds. In this new and unique setting, we derive estimates of the price elasticity of demand of U.S. equities which are low and support the inelastic markets hypothesis. More broadly, our paper documents a striking case of investment distortions induced by suboptimal financial regulation.

The spread between corporate and sovereign bond yields cannot be explained by differences in default risk alone. Instead, there is a significant non-default component that has traditionally been associated with the “convenience” of holding a particular asset. We use comprehensive portfolio holdings data from the euro area corporate bond market to shed light on the asset specific “services” that give rise to such convenience yields. Using precise proxies for four services — liquidity, duration, regulatory capital and collateral value — we find that, during the last decade, convenience yield has been overwhelmingly driven by insurance corporations’ and banks’ desire for bonds with low regulatory capital requirements. Moreover, we show that policy-induced shocks to such services significantly affected asset prices and allocations through the convenience yield component. Our results underscore the importance of assets pecific service flows in driving bond valuation and shaping monetary policy transmission.