Fund Flows and Stock Returns: Uncovering the Transmission Mechanisms

Abstract

Fund flows, directly reflecting capital movements in financial markets, are central to asset pricing research on their relationship with stock returns. Existing studies have predominantly examined either their direct price pressure effect or indirect influences from isolated perspectives, such as behavioral finance or liquidity, lacking a systematic integration of multiple transmission channels. To address this gap, this paper develops a comprehensive "quadruple parallel mediation model" to fully unveil the complex mechanisms through which fund flows affect stock returns. Based on China's A-share market data from 2008 to 2024, this study employs a standardized empirical approach. First, a standardized fund flow measure is constructed following Bennett and Sias [1]. Second, intermediary variables: investor sentiment, market illiquidity, and stock price non-synchronicity are developed using text analysis and market microstructure data. Finally, a parallel multiple mediation model is established to simultaneously test both the direct effect of fund flows on stock returns and their transmission through three key indirect channels. The empirical findings reveal that: (1) Fund flows exhibit a robust positive contemporaneous total effect on stock returns. (2) Fund flows affect returns simultaneously through three parallel channels: boosting investor sentiment, inducing a liquidity premium, and promoting information incorporation. These multiple transmission mechanisms coexist. (3) The mechanisms show significant market state heterogeneity, with their modes of action dynamically changing across bull and bear markets. This study transcends single-theory explanations by integrating price pressure, investor sentiment, liquidity premium, and information hypotheses into one analytical framework, offering comprehensive empirical evidence for investors and regulators.