A new empirical paper looks at the drivers of U.S. mutual funds flows across asset classes. An important finding is that changes of monetary policy expectations towards tightening trigger net outflows from bond funds and net inflows into equity funds. Typically, the costs of redemptions are borne by investors that do not redeem or redeem late. This creates incentives for fire sales and causes of price distortions, particularly if the outlook for monetary policy is revised significantly.

Banegas, Ayelen, Gabriel Montes-Rojas and Lucas Siga (2016). “Mutual Fund Flows, Monetary Policy and Financial Stability,” Finance and Economics Discussion Series 2016-071. Washington: Board of Governors of the Federal Reserve System

The post ties in with the summary page on price distortions, particularly the section on redemptions.

The below are excerpts from the paper. Headings and cursive text have been added.

The drivers of mutual fund flows

“After declining by about 35 percent in 2008, U.S. long-term mutual fund assets [rose] dramatically, with total net assets increasing from $5.7 trillion to $13.1 trillion by the end of 2014.”

“We use [for empirical analysis] monthly data on net new flows and total net assets on the 51 ICI investment categories on long-term mutual funds (namely bond, equity, and hybrid funds) domiciled in the United States over the 2000-14 period…We find that monetary policy shocks, past fund returns, and a set of macroeconomic and financial aggregates can help explain mutual fund flow dynamics and that drivers of flows differ by investment strategy.”

“We document that monetary policy has a direct influence on the behavior of mutual fund investors. Specifically, our results show that positive monetary policy shocks (tightening) can trigger outflows in funds investing in fixed-income securities and inflows into international equity funds.”

flow_fire01

flow_fire02

“For the bond market, results show that a tightening of monetary policy [i.e. positive one standard deviation shocks to the fed funds target rate] will translate into a 0.4 to 0.5 standard deviation increase in the flow-to-assets ratio, and a positive path shock [surprises about future policy based on forecasts and surveys]  will produce outflows on the order of 0.8 standard deviation…For equity, the effect of monetary path shocks on flow of funds investing in equity markets is negative for target shocks (0.2 to 0.4 standard deviation) and positive for path shocks (0.5 standard deviation). These findings are consistent with the argument that as the economy improves, investors will shift their portfolio allocations from safe-haven to riskier assets.”

“Although flow of funds investing in the government, municipal, investment-grade, and multisector bond markets exhibit a counter- cyclical relationship with macro conditions, high-yield bond flows show a cyclical pattern, similar to equity flows.”

The risk of fire sales

“Under the current regulatory framework in which redemption costs are mutualized and mutual funds engage in liquidity transformation, our findings suggest that there are economic incentives that may generate a first-mover advantage.”

“By offering investors the possibility of daily redemption of their shares, mutual funds investing in illiquid assets engage in liquidity transformation…As fund managers need to liquidate less liquid positions to meet redemptions, they might generate downward price pressure on the underlying assets…The cost will be borne by those who remained invested in the fund…This ‘mutualization’ of redemption costs could potentially lead to fire sales, as investors will have economic incentives to redeem ahead of the anticipated outflows.”

“There is concern among policymakers and some market participants about how mutual fund investors and asset managers will respond to monetary policy normalization…The…’taper tantrum’ in 2013 and the emerging markets selloff in 2014 centred the debate primarily on bond mutual funds and the potential implications for financial stability of massive redemptions affecting less liquid segments of the bond market.”