Mutual Fund Cash Flows and Stock Market Performance*
During the decade of the 1990’s through the year 2001 there were some major shifts in the deployment of investment assets. Based on a variety of measures, mutual funds grew dramatically as vehicles for investing in portfolios of stock. Specifically net cash flows into equity funds grew from $13 billion in 1990 to $310 billion in the year 2000.1 During that same period the number of equity funds rose from 1,100 to 4,395, while the number of accounts in those funds increased from 22 million to 162 million. The cumulative effect of the new money injected into equity funds, together with reinvestment of dividends, plus the attendant stock price appreciation has produced a phenomenal growth in total net assets. The market value of those assets mushroomed from $239 billion in 1990 to $3,962 billion in 2000.
Granted that funds have become major players in equity markets, how important is their influence compared to other drivers of market performance? The investment press and business news media normally concentrate their attention on earnings growth, interest rate movements and other relevant financial and economic indicators. However, there is very little in the professional and academic investment literature comparing the impact of mutual fund cash flows to the aforementioned variables. The purpose of this study is to provide some focus, comparison, and perspective on the importance of mutual fund flows. It presents evidence that mutual fund flows may be a very significant factor in explaining monthly-movements in stock market returns, and it provides some estimates on just how large the impact might be. Specification of Variables and Causal Relationships
The basic model deployed in our study includes other important factors and liquidity variables in addition to mutual fund flows. The model specifies that the return on the stock market is a function of net flows into equity mutual funds, the growth rate of the M2 money supply, changes in the federal funds rate, and growth of earnings per share. This study recognizes and acknowledges that movements of money into the stock market through mutual funds are linked to general business conditions. Clearly, company earnings and revenues and the external economic environment in which firms operate will influence investor decisions. However, that linkage between business performance and commitment of money to stocks is not rigid. Over short-term periods and even over extended lengths of time, masses of investors may be afflicted with either “irrational exuberance,” or they may be descending down a “wall of worry”. The latter situations characterize opposite poles in the spectrum of investor psychology, and they can generate tides of money flows to and from equity funds even if the fundamentals do not support those flows. Data
The dependent variable in our study, stock market performance, was measured by the total return on the S&P 500 composite index (RM). The data spans the period from January 1990 through January 2001. Because flows of funds into mutual funds are reported on a monthly basis, and because those flows would presumably have the greatest impact concurrently to the flow, monthly data were used in the study. Statistics on net cash flows into stock mutual funds are available from the Investment Company Institute. During the years of the study, the stock market grew in terms of dollar volume of shares traded. It is, therefore, important to properly adjust the data on dollars flowing into equity funds for the growth of trading in the market. For this reason the monthly flow numbers were divided by the corresponding dollar value of monthly trading volume on the New York Stock Exchange. In other words, the higher the ratio (MF) of mutual fund flows to the dollar volume of trading in the market, the more important those flows become in that particular month. In summary, MF, the ratio of...
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