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Correlated Flows, Portfolio Overlap and Mutual Fund Liquidity Management

We contend that confluence of portfolio overlap and correlated liquidity shocks within mutual fund styles can exacerbate fund exposure to flow-driven liquidity risk. We show that funds mitigate such liquidity risk by reducing portfolio overlap with peer funds when their flows become more correlated (Overlap Management). Overlap Management is a highly persistent fund attribute and less costly compared to other liquidity management tools. It contributes to fund performance by avoiding correlated trades and thus alleviates the negative feedback effect of outflows on future performance. The effect of Overlap Management on performance is economically significant and is independent of that of portfolio uniqueness or alternative liquidity management tools. Using several different approaches, we show that our findings cannot be explained by potential endogeneity between flow correlation and portfolio overlap.