Individual investor mutual fund flows

This paper studies the relation between individuals’ mutual fund flows and fund characteristics, establishing three key results. First, consistent with tax motivations, individual investors are reluctant to sell mutual funds that have appreciated in value and are willing to sell losing funds. Second, individuals pay attention to investment costs as redemption decisions are sensitive to both expense ratios and loads. Third, individuals’ fund-level inflows and outflows are sensitive to performance, but in different ways. Inflows are related only to “relative” performance, suggesting that new money chases the best performers in an objective. Outflows are related only to “absolute” fund performance, the relevant benchmark for taxes.     

Mutual fund flows,expected returns,and the real economy

This paper investigates the relation between mutual fund flows and the real economy. The findings of this paper support the theory that the positive co-movement of flows into equity funds and stock market returns is explained by a common response to macroeconomic news. Variables that predict the real economy as well as the equity premium – in particular dividend-price ratio, default spread, relative T-Bill rate and consumption-wealth ratio – are related to fund flows and can account for the correlation of flows and market returns. Furthermore, consistent with the information-response hypothesis, mutual fund flows are forward-looking and predict real economic activity.     

Mutual fund portfolio trading and investor flow

I estimate the extent to which mutual fund portfolio trading of securities is triggered by investor flows into and out of the funds, and find that this liquidity-induced portfolio trading activity is smaller than previously estimated by Edelen (1999). I obtain estimates from a much larger and broader sample of funds than Edelen’s (1999) sample. Portfolio managers of international funds trade a smaller fraction of investor flow than do those of domestic funds. Index funds invest a larger fraction. A funds’ usage of futures contracts does not have a statistically significant effect on how it trades in response to investor flows, but the unpredictability of investor flow weakly affects the trading response to flow.     

Mutual fund risk and market share-adjusted fund flows

Several papers use a fractional specification (net inflow/ assets under management) to infer a convex relation between flow and past performance. However, heterogeneous linear response functions combined with the pooled analysis commonly used in these studies can yield false convexity estimates. We show that such heterogeneity obtains in practice. Along these same lines, the paper also finds that several previously unexamined implications of a convex flow-performance relation fail to hold. Moreover, convexity with fractional flows (which we confirm) largely disappears in a conditional analysis that controls for heterogeneity. Market shares offer an alternative specification for flow that is more resilient to heterogeneity. Using this alternative specification, we again find no evidence of convexity in the flow-performance relation. We conclude that the widely held belief that the flow response function is convex is due solely to misspecification of the empirical model. The flow-return relation is linear.     

Measuring investor sentiment with mutual fund flows

We investigate a proxy for monthly shifts between bond funds and equity funds in the USA: aggregate net exchanges of equity funds. This measure (which is negatively related to changes in VIX) is positively contemporaneously correlated with aggregate stock market excess returns: One standard deviation of net exchanges is related to 1.95% of market excess return. Our main new finding is that 85% (all) of the contemporaneous relation is reversed within four (ten) months. The effect is stronger in smaller stocks and in growth stocks. These findings support the notion of “noise” in aggregate market prices induced by investor sentiment.     

Mutual fund volatility timing and management fees

This paper shows that compensation incentives partly drive fund managers’ market volatility timing strategies. Larger incentive management fees lead to less counter-cyclical or more pro-cyclical volatility timing. But fund styles or aggregate fund flows could also account for this relation; therefore, we control for them and find that the relation between fees and volatility timing still holds. Results show that less aggressive fund styles are associated with pro-cyclical volatility timing, and that volatility timing and flow timing are negatively related. We also find that pro-cyclical timing mostly improves funds’ average excess returns, Sharpe ratios, and alphas.     

Capacity constraints,investor information,and hedge fund returns

To identify capacity constraints in hedge funds and simultaneously gauge how well-informed hedge fund investors are, we need measures of investor demand that do not affect deployed hedge fund assets. Using new data on investor interest from a secondary market for hedge funds, this paper verifies the existence of capacity constraints in hedge funds. There is more mixed evidence on the information available to hedge fund investors. Buy and sell indications arrive following fund outperformance. While buy indications have little incremental power to predict hedge fund performance over and above well-known forecasting variables, sell indications do somewhat better.     

Dumb money: Mutual fund flows and the cross-section of stock returns

We use mutual fund flows as a measure of individual investor sentiment for different stocks, and find that high sentiment predicts low future returns. Fund flows are dumb money–by reallocating across different mutual funds, retail investors reduce their wealth in the long run. This dumb money effect is related to the value effect: high sentiment stocks tend to be growth stocks. High sentiment also is associated with high corporate issuance, interpretable as companies increasing the supply of shares in response to investor demand.     

The dynamics of short-term mutual fund flows and returns: A time-series and cross-sectional investigation

This study analyzes the dynamics of daily mutual fund flows. A Vector Auto Regression (VAR) of flows and returns shows that the behavior of fund investors is more consistent with contrarian rather than momentum characteristics. Past fund flows have a positive impact on future fund returns, with the long-term information effect dominating the transient price-pressure effect. Seasonality in daily flows, such as day-of-week and day-of-month patterns are present, and daily flows are generally mean-reverting. Probit regressions indicate that fund investment objective, marketing policy and level of active management explain cross-sectional variation in the behavioral patterns displayed in daily flows. Our results are robust to the different methods of calculating daily flows based on whether or not the day-end TNA figures include the current-day’s flow. Throughout the analysis, we contrast the dynamics of daily flows with established results for monthly fund flows and find important differences between the two.     

An empirical analysis of Mexican and US closed-end mutual fund IPOs

We examine 135 Mexican closed-end fund IPOs and 370 Mexican non-fund IPOs that issued between 1994 and 2003 along with 217 contemporaneous US fund IPOs and document three primary results. First, we find that Mexican IPOs in the aggregate experience no significant underpricing, unlike their US IPO counterparts. Both Mexican and US IPOs experience significantly negative long-run performance. Second, Mexican closed-end fund IPOs experience positive long-run performance, significantly better than Mexican non-fund IPOs which experience negative long-run performance. Unlike Mexican fund IPOs, US fund IPOs experience negative long-run performance. Third, we find that both Mexican and US debt-backed closed-end fund IPOs significantly outperform equity-backed closed-end IPOs. In Mexico, debt-backed funds experience positive abnormal returns, compared to negative abnormal returns for Mexican equity-backed funds, US debt-backed funds, and US equity-backed funds.     

Macroeconomic risk and hedge fund returns

This paper estimates hedge fund and mutual fund exposure to newly proposed measures of macroeconomic risk that are interpreted as measures of economic uncertainty. We find that the resulting uncertainty betas explain a significant proportion of the cross-sectional dispersion in hedge fund returns. However, the same is not true for mutual funds, for which there is no significant relationship. After controlling for a large set of fund characteristics and risk factors, the positive relation between uncertainty betas and future hedge fund returns remains economically and statistically significant. Hence, we argue that macroeconomic risk is a powerful determinant of cross-sectional differences in hedge fund returns.     

The dynamics between stock returns and mutual fund flows: empirical evidence from the Greek market

This paper examines the interaction between mutual fund flows and stock returns in Greece. Specifically, we investigate the possibility of a causality mechanism through which mutual funds flows may affect stock returns and vice versa. The statistical evidence derived from the error correction model indicates that there is a bidirectional causality between mutual fund flows and stock returns. Cointegration results show that mutual funds flows cause stock returns to rise or fall. This may be explained by the fact that, in Greece, equity mutual funds are obliged by law to invest a certain percentage of their cash in stocks. Thus, inflows and outflows of cash in equity funds seem to cause higher and lower stock returns in Greek stock market.     

Identifying the interaction between stock market returns and trading flows of investor types: Looking into the day using daily data

This paper introduces a new method for identifying the simultaneity between returns and trading flows. The proposed method enables us to identify the intraday interaction using daily data, and provides measures of the information content of trading flows, and their instantaneous response to public information and information revealed by market prices. Applying this method to daily data on investor types from the Korea Stock Exchange, we find significant intraday bi-directional interaction between flows and returns and their latent common drivers, altering some of the results of the previous literature based on Cholesky assumptions. Thus, we obtain a number of new insights concerning the behavior of investor types.     

Mutual fund performance evaluation with active peer benchmarks

We propose a simple approach to account for commonalities in mutual fund strategies that relies solely on information on fund returns and investment objectives. Our approach augments commonly used factor models with an additional benchmark that represents an equal investment in all same-category funds, which we call an active peer benchmark (APB). We find that APBs substantially reduce the average time series correlation of residuals between individual funds within a group when added to a four-factor equity model (or to a seven-factor fixed-income model). Importantly, adding this APB significantly improves the selection of funds with future outperformance.     

Detecting structural breaks and identifying risk factors in hedge fund returns: A Bayesian approach

Extending previous work on asset-based style factor models, this paper proposes a model that allows for the presence of structural breaks in hedge fund return series. We consider a Bayesian approach to detecting structural breaks occurring at unknown times and identifying relevant risk factors to explain the monthly return variation. Exact and efficient Bayesian inference for the unknown number and positions of the breaks is performed by using filtering recursions similar to those of the forward–backward algorithm. Existing methods of testing for structural breaks are also used for comparison. We investigate the presence of structural breaks in several hedge fund indices; our results are consistent with market events and episodes that caused substantial volatility in hedge fund returns during the last decade.     

Higher risk,lower returns: What hedge fund investors really earn

The returns of hedge fund investors depend not only on the returns of the funds they hold but also on the timing and magnitude of their capital flows in and out of these funds. We use dollar-weighted returns (a form of Internal Rate of Return (IRR)) to assess the properties of actual investor returns on hedge funds and compare them to buy-and-hold fund returns. Our main finding is that annualized dollar-weighted returns are on the magnitude of 3% to 7% lower than corresponding buy-and-hold fund returns. Using factor models of risk and the estimated dollar-weighted performance gap, we find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns are reliably lower than the return on the Standard & Poor's (S&P) 500 index, and are only marginally higher than the risk-free rate as of the end of 2008. The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought.     

Derivative use,fund flows and investment manager performance

Prior literature which examines the use of derivatives by investment managers does not discern between different types of derivative trading strategies. This study is the first to examine and gather data on a particular type of derivative trading strategy undertaken by investment managers. We examine the extent to which equity fund managers use index futures to manage fund flows and the effect this has on their alpha and market timing measures of performance. Our results show that funds that do not use derivatives exhibit lower returns and negative market timing skills when they experience fund flow. The performance of funds that use derivatives, however, is independent of investor’s liquidity demands. In fact, the unconditional performance of the average user fund is statistically equivalent to the performance of the average non-user fund conditional on zero fund flow. Our results provide evidence that derivatives can be beneficial for mutual fund holders under certain conditions.     

Value at risk and the cross-section of hedge fund returns

Using two large hedge fund databases, this paper empirically tests the presence and significance of a cross-sectional relation between hedge fund returns and value at risk (VaR). The univariate and bivariate portfolio-level analyses as well as the fund-level regression results indicate a significantly positive relation between VaR and the cross-section of expected returns on live funds. During the period of January 1995 to December 2003, the live funds with high VaR outperform those with low VaR by an annual return difference of 9%. This risk-return tradeoff holds even after controlling for age, size, and liquidity factors. Furthermore, the risk profile of defunct funds is found to be different from that of live funds. The relation between downside risk and expected return is found to be negative for defunct funds because taking high risk by these funds can wipe out fund capital, and hence they become defunct. Meanwhile, voluntary closure makes some well performed funds with large assets and low risk fall into the defunct category. Hence, the risk-return relation for defunct funds is more complicated than what implies by survival. We demonstrate how to distinguish live funds from defunct funds on an ex ante basis. A trading rule based on buying the expected to live funds and selling the expected to disappear funds provides an annual profit of 8–10% depending on the investment horizons.     

Systematic risk and the cross section of hedge fund returns

This paper investigates the extent to which market risk, residual risk, and tail risk explain the cross-sectional dispersion in hedge fund returns. The paper introduces a comprehensive measure of systematic risk (SR) for individual hedge funds by breaking up total risk into systematic and fund-specific or residual risk components. Contrary to the popular understanding that hedge funds are market neutral, we find that systematic risk is a highly significant factor explaining the dispersion of cross-sectional returns while at the same time measures of residual risk and tail risk seem to have little explanatory power. Funds in the highest SR quintile generate 6% more average annual returns compared with funds in the lowest SR quintile. After controlling for a large set of fund characteristics and risk factors, systematic risk remains positive and highly significant, whereas the relation between residual risk and future fund returns continues to be insignificant. Hence, systematic risk is a powerful determinant of the cross-sectional differences in hedge fund returns.     

An empirical analysis of the dynamic relationship between mutual fund flow and market return volatility

We study the dynamic relation between aggregate mutual fund flow and market-wide volatility. Using daily flow data and a VAR approach, we find that market volatility is negatively related to concurrent and lagged flow. A structural VAR impulse response analysis suggests that shock in flow has a negative impact on market volatility: An inflow (outflow) shock predicts a decline (an increase) in volatility. From the perspective of volatility–flow relation, we find evidence of volatility timing for recent period of 1998–2003. Finally, we document a differential impact of daily inflow versus outflow on intraday volatility. The relation between intraday volatility and inflow (outflow) becomes weaker (stronger) from morning to afternoon.