When is Money Smart? Mutual Fund Flows, Energy Prices, and Household Disposable Income

Abstract

This study shows that the representative investor’s sophistication in the market for mutual funds is time-varying, and increases with the constraints on household disposable income at the aggregate level. Based on the fact that energy commodities are largely inelastic household expenditures that reduce disposable income, I use changes in retail energy prices to proxy for short-run exogenous changes in the disposable income of potential investors. New money flows to actively managed U.S. equity mutual funds decrease with the constraints on disposable income, ceteris paribus. The representative investor shows fund selection and timing ability only in periods when the constraints on disposable income sharply increase, but does not display discernable ability unconditionally. Fund flows are more rationally sensitive to price (i.e. fees and loads) and funds’ past risk-adjusted performance when the constraints on disposable income increase. The results are also consistent with the representative fund investor displaying more aversion towards funds associated with more agency problems and inferior manager skill in periods when the constraints on disposable income increase.