In the bi-variate VAR we find that returns do help in predicting flows over and above the predictability of past flows. So the “trend-chasing” characteristic of the data meets the more stringent test. Past flows also remain important for predicting future flows once lagged returns are included. However, the statistical significance of lagged returns falls considerably. On the prediction of returns, we are unable to detect statistically that flows have incremental forecasting value over and above lagged returns, although the correlation between flows and returns tends to reduce the power of our tests.

By using the data alone, we can verify association, but not causality. To understand the implications of a specific causal structure, we lay out a simple structural model of flows and returns. In this model, inflows are driven by past flows and past returns, while returns are driven by current and past flows. This model seems reasonably realistic; for example, it endogenizes the commonly-observed autocorrelation properties of index returns. Using the model, we can trace out the dynamic impact on prices and portfolio holdings of exogenous shocks to inflows and returns.

Our main finding here is that the impact of exogenous flows on returns is strongly significant. Furthermore, we find that if the exogenous flow is transitory, prices tend to decline once the inflow recedes. In other words, an exogenous shock to flows appears to generate expectations of additional future flows. The current price increase seems to recognize this, increasing by more in anticipation of further future flows. If the future inflows do not materialize, then prices decline. No actual net outflow is required.
Finally, our data have interesting implications for the recent crisis in Asia. Although we find that international investors appear to have incremental information in Asia generally, we find no evidence that they were more informed than their counterparties during the crisis; indeed, they appear to be marginally less well-informed.

In addition, while international investors show signs of trend chasing during the full sample, returns are negative predictors of future inflows during the Asian crisis. Taken together these facts suggest that, during the crisis, the cross-Asian correlation of international inflows is much higher in daily data than would be revealed by looking at lower horizon aggregations.

The rest of the paper is organized as follows. Section II provides a brief summary of related literature. Section III discusses the data in more detail and provides summary statistics and variance ratios of flows. Section IV examines the correlation of returns and flows. It begins by distinguishing several hypotheses of interest, then presents covariance ratios used to test these hypotheses. Our bivariate, vector autoregressions are then presented in Section IV. Section V concludes.