Mutual Funds and Stock and Bond Market Stability

Abstract

The past decade's bull market in U.S. stock market and the experience in recent Asian financial crisis raised interesting questions on the impact of institutional investors (mutual funds, pension funds and hedge funds) on financial markets. Mutual funds in US have experienced unprecedented growth in recent years. Many believe that the U.S. equity bull market of the 1990's is attributable to the huge flows of funds into equity mutual funds during this period, and that a withdrawal of those funds could send stock prices plummeting. This article investigates the relationship between aggregate monthly mutual fund flows (sales, redemptions, and net sales) and stock and bond monthly returns during a 30-year period beginning January l961, utilizing both Granger causality and instrumental variables analysis. We also tests a variety of financial theories that may explain how mutual funds may affect financial markets. The main findings are as follows. First, on whether flows cause return, with one exception, flows into stock and bond funds have not affected either stock and bond returns. The exception is 1971-81, when widespread redemptions from equity mutual funds significantly depressed stock returns. On the other hand, on whether returns cause flows, the magnitude of flows into both stock and bond funds are significantly affected by stock and bond returns. These findings suggest, first, that the recent run-up in stock prices cannot be attributed to the rapid growth of equity mutual funds during the 1980's and 1997's; and, second, that the possibility of a mutual-fund-induced downward price spiral in stock prices cannot be ruled out. The results for the 1971-81 period suggest that in a down stock market, when stock returns are low and mutual fund redemptions are high, outflows of funds from mutual funds could put downward pressure on stock prices. This is consistent with a noise-trader view of markets. It should be recognized, however, that current mutual fund investors are different from those during 1971-81. Today, more than half of stock and bond mutual fund assets owned by households are held in some type of retirement plan. Thus, current mutual fund investors may have different investment objectives and longer investment horizons than those in 1971-81, and may behave differently in a market downturn.