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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”.
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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 monthly mutual fund flows to monthly dollar trading volume, is the index which we use to measure the magnitude of fund flows relative to the market.
The second explanatory variable in our study (M2) was the monthly growth rate of the M2 money supply. This variable may be viewed as a measure of the change in national monetary liquidity. Money supply growth also influences the stock market through its impact on general business conditions and economic activity. The third flow related variable, monthly changes in the federal funds rate (FF), provides information on the Federal Reserve’s efforts to stimulate or dampen the future growth of financial liquidity. Both fixed-income and equity markets pay close attention to Federal Reserve efforts to encourage or restrict economic growth through interest rate changes.
The final variable was an index of corporate profit growth (EPS). Earnings per share on the S&P 500 index was available on a quarterly basis, and using interpolation, monthly estimates of earnings were obtained. The growth rate of the estimated monthly earnings was calculated as the percentage change from the same calendar month of the prior year. In essence we applied the same type of comparisons used when companies contrast their most recent quarterly results to the same quarter of the previous year. This also has the effect of reducing problems associated with seasonal variations.2
Results of the analysis are presented in Equation (1) with the t-statistics shown in parentheses. The three flow-related variables (MF, M2, FF) were all statistically significant. The most significant, as measured by the size of the t statistic, was the flow into stock mutual funds. As indicated earlier, previous studies on stock returns (for example, see journal articles in the References section) say little if anything about the quantitative impact of mutual fund flows.
(1) RM = -.030 + .791 MF + 3.l87 M2 - .0747 FF + .0222 EPS
(-3.32) (4.84) (2.51) (-3.74) (1.26)
[R2 = 24%]
The second most significant variable was the direction of Federal Reserve policy as measured by changes in the Federal funds rate. The negative sign is consistent with rising rates having a negative effect on stock returns. The old adage of “Don’t fight the Fed” is supported in our results. In addition, the growth rate of M2 was also significant. In other words, money supply growth, in addition to changes in the Federal funds rate is an important monetary policy variable.
The fourth explanatory variable, growth of earnings per share (EPS), was positive as expected, but it was not statistically significant (at the 5% level). Obviously earnings are a critical element in the determination of stock prices and the lack of a higher level of significance is likely caused by a variety of factors linked to the reporting of earnings. For example, announcement effects of most earnings reports occur early in the following quarter at which time they are typically released. Another factor affecting results might be negative pre-announcements of earnings. These frequently occur in the month prior to the actual earnings report, and market prices of many companies may adjust at that point. Moreover, the actual rate of earnings growth may be less important than whether companies are meeting or surpassing market expectations. Other complications may occur if companies report that earnings are in line with expectations but simultaneously announce that they are changing guidance for future quarters. If most companies are reporting poor earnings, but are also raising guidance for quarters that will follow, the market may rise rather than fall. Finally, some earnings numbers are inflated and distorted due to accounting methods related to special charges which are taken at a later date.3 This too may affect the significance of reported earnings on market performance.
The most important point of this study, however, is that the findings with regard to mutual fund flows are particularly interesting. The signs of the coefficients of all of the explanatory variables in Equation (1) are consistent with financial theory, and it is noteworthy that the mutual fund variable has the strongest level of significance.4
Importance of Fund Flows
Equation (1) may be used to estimate how important fund flows are to monthly stock market returns. In December 2000 mutual fund flows were $11.64 billion which would correspond to 1.3% of the December monthly trading volume on the New York Stock Exchange. Given that information and the values of the other variables during December, the model predicted a monthly return of .73% (compared to an actual return of .49%).5 If the December 2000 flow had been $10 billion higher, $21.64 billion would have gone into equity funds. (The average monthly number for all months of the year 2000 was $25.8 billion). In that situation, given the same value for the other explanatory variables, the model would have predicted a return of 1.61% for December, an increase of .88%. Annualizing this number translates into an additional return of approximately 10.6%. Even given the existence of some statistical error, the impact of mutual fund flows appears to be far from trivial.
Summary and Conclusions
This study has provided evidence that mutual fund flows have been quite important as a determinant of monthly stock market returns. In addition, it presents some estimates on just how large the impact might be. The findings also suggest that some managers of large fund families and sector funds may be in a position to receive a form of privileged information. Those who know at an early stage how investors are redeploying their money may be able to profit with this knowledge. By moving early into the favored sectors and out of the sectors being abandoned, there would appear to be some worthwhile short-term opportunities, especially given the existence of momentum players and others who might be looking where the market shows strength and weakness.
* The authors express their thanks to an anonymous referee for providing helpful comments and suggestions
1. Statistics were obtained from Mutual Fund Fact Book, 2001.
2. This methodology was recently used by White (2000).
3. See Liesman and Weil (2001).
4. One interpretation of the results of this study is that “. . . a Ricardian rent (from scarcity) went to capital owners during that period, since everybody wanted to buy equity, but equity was rationed.” We thank an anonymous referee who provided this observation.
5. To utilize Equation (1) numbers should be inserted in decimal format. For example, if EPS growth was 10%, substitute .10 into the equation.
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