TAILIEUCHUNG - Market Returns and Mutual Fund Flows

It is, of course, after the stock market has had a large rise that the magnitude of unrealized capital gains in mutual fund portfolios becomes an important consideration. It is presumably because the stock market has performed so well over the past seventeen years that mutual funds have had to employ such high turnover rates to keep their unrealized gain problems under control. The continuing severity of this problem, in spite of these high turnover rates, however, is illustrated by the following survey of the. | Market Returns and Mutual Fund Flows Eli M. Remolona Paul Kleiman and Debbie Gruenstein The 1990s have seen unprecedented growth in mutual funds. Shares in the funds now represent a major part of household wealth and the funds themselves have become important intermediaries for savings and investments. In the United States more than 4 000 mutual funds currently hold stocks and bonds worth a total of more than 2 trillion Chart 1 . Household investment in these funds increased more than fivefold in the last ten years making it the fastest growing item on the household financial balance sheet. Most of this growth came at the expense of more traditional forms of savings particularly bank deposits. With the increased popularity of mutual funds come increased concerns namely could a sharp drop in stock or bond prices set off a cascade of redemptions by fund investors and could the redemptions exert further downward pressure on asset markets In recent years flows into funds have generally been highly correlated with market returns. That is mutual fund inflows have tended to accompany market upturns and outflows have tended to accompany downturns. This correlation raises the question whether a positivefeedback process is at work here in which market returns cause the flows at the same time that the flows cause the returns. Observers such as Hale 1994 and Kaufman 1994 fear that such a process could turn a decline in the stock or bond market into a downward spiral in asset In this study we use recent historical evidence to explore one dimension of the broad relationship between market returns and mutual fund flows the effect of shortterm market returns on mutual fund flows. Research on this issue has already confirmed high correlations between market returns and aggregate mutual fund flows Warther 1995 . A positive-feedback process however requires not just correlation but two-way causation between flows and returns in which fund investors react to market movements

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