Asset Allocation Decisions of Mutual Fund Investors

Abstract I extend the Warther (1995) evidence to show that stock market returns are related to contemporaneous flows into mutual funds that invest in risky stocks and bonds, but are unrelated to flows into funds that invest in safer stocks and bonds. I examine whether common sources of predictability in returns and flows can explain this contemporaneous relation. I find that variables with predictive ability for stock returns, such as the lagged one-month T-bill rate and the lagged term premium, also predict flows into the risky categories of mutual funds. © 2004 Academy of Financial Services. All rights reserved. Keywords: Mutual funds; Asset allocation; Personal investing; Predictability in stock and bond returns 1. Introduction Mutual funds have increased in popularity over the last 20 years. According to the Investment Company Institute (ICI), assets under management have grown from $50 billion in the early 1970s to $6.4 trillion by the end of 2002. ' The increase in popularity of mutual funds has led to speculation in the popular press that stock market returns respond to price pressure created by fund flows. Academic literature has thus far shown only weak support for this price pressure hypothesis (Warmer, 1995; Adler and Yi, 1998; Edelen and Warner, 2001; Goetzmann and Massa, 1999). In the first part of this paper, I re-examine the flow-return relation to determine whether a different classification of mutual funds than the one adopted by Warther (1995) provides stronger support for the price pressure hypothesis. I find that flows into high-risk categories, whether stock funds or bond funds, are significantly related to contemporaneously measured stock and bond returns. However, flows into low-risk stock and bond funds are unrelated to stock market returns. The introduction of risk into the flow-return relation as a factor suggests that price pressure can only be a partial explanation for the relation between flows and market returns. I examine an alternate hypothesis that aggregate flows and market returns respond to common sources of predictability. Single (Merton, 1980; Friend and Blume, 1975) and multiperiod models (Ait-Sahalia and Brandt, 2001) of the optimal investment and consumption policies of a risk averse investor demonstrate that investors' allocation of their wealth to a risky asset depends on the expected return to the risky asset, on the expected volatility of returns and on the coefficient of relative risk aversion. These models imply that variables that can predict future expected returns and future volatility should also predict flows into risky categories of mutual funds. I identify a set of instrumental variables to proxy for time-variation in the distribution of stock and bond returns,3 and test whether these instrumental variables can predict aggregate flows into the various categories of mutual funds. The tests show that the one-month T-bill rate and the term premium, variables that have been shown to predict future market returns, also predict flows into the four fund categories. Variables with predictive power for future volatility can predict flows into low-risk stock and low-risk bond funds. Finally, Ilmanen's (1995) proxy for time-varying risk aversion has weak predictive power for flows into high-risk stock and bond funds. Overall, the various instrumental variables have the highest explanatory power for flows into low-risk bond funds (R^sup 2^ = 22.03%) and the lowest explanatory power for flows into high-risk bond funds (R^sup 2^ = 6.88%). It is well known that mutual fund investors chase past performance (Chevalier and Ellison, 1997; Sirri and Tufano, 1998) in selecting individual mutual funds. Other studies examine how fund loads, expenses and other fund-specific variables affect inflows into individual mutual funds (Cook and Hebner, 1992/1993). These papers focus on the selection of individual mutual funds. Yet it is well known that the portfolio allocation decision is an even more critical determinant of portfolio performance than the selection of individual funds. …