Economic Conditions, Flight-to-Quality and Mutual Fund Flow

Abstract

We study the effects of economic conditions and destabilizing events on the aggregate asset allocations of mutual fund investors. In the universe of U.S. mutual funds between 1991 and 2008, we find that excess flow is consistently related to proxies for economic conditions. An expected improvement in economic conditions causes investors to direct flow away from relatively safe money market funds and towards riskier equity funds. Around major crises, we find evidence of flight-to-quality, that is, significant flow into money market funds and out of equity funds. The same patterns exist in the population of Canadian mutual funds. Flow for low fee or low turnover funds, likely to be held by sophisticated investors, shows a sharper reaction to economic conditions and crises. Consistent with these allocations being a response to economic conditions, we find that high money market flow is associated with high T-bill returns, and that this association weakens once we control for economic conditions. We estimate that investors with moderate to high levels of risk aversion receive higher utility by switching between money market and equity funds in anticipation of changes in economic conditions, relative to a buy-and-hold strategy in equities.