Avoiding Idiosyncratic Volatility: Flow Sensitivity to Individual Stock Returns

This paper identifies a novel source of limits to arbitrage: holding-level flow-performance sensitivity. Fund investors withdraw capital following extreme negative returns of individual holdings, even after controlling for overall fund performance. Anticipating such redemptions, fund managers strategically reduce exposure to stocks expected to experience elevated idiosyncratic volatility—such as those approaching earnings announcements or implied volatility spikes. This precautionary behavior is costly before earnings announcements due to a significant pre-announcement premium. Consistent with this mechanism, funds more vulnerable to outflows exhibit stronger abnormal selling ahead of earnings announcements. A formal model captures the underlying tradeoff between expected returns and redemption risk.