Mutual Funds And Stock And Bond Market Stability

MUTUAL FUNDS AND STOCK AND BOND MARKET STABILITY by Franklin R. Edwards 625 Uris Hall Graduate School of Business Columbia University New York, NY 10027 Telephone: 212-854-4202 and Xin Zhang The World Bank 1818 H Street, N.W. Washington, DC 20433 Telephone: 202-458-4783 Email: Xzhang2@worldbank.org Forthcoming Journal of Financial Service Research _____________________________ * Franklin R. Edwards is the Arthur F. Burns Professor of Free and Competitive Enterprise at the Graduate School of Business of Columbia University. Xin Zhang is a Financial Economist of the Capital Markets Development Department of the World Bank. We wish to thank members of the ÒFree LunchÓ Finance Group at the Columbia Business School, participants in the Economics Workshop at the Graduate School of the City University of New York and the Conference of Ten-years Since Crash at Owen School of Business of Vanderbilt University, and especially George Benston, Hans Stoll, and John Rae for helpful comments. The Investment Company Institute graciously provided mutual fund data. ABSTRACT The unprecedented growth of mutual funds has raised questions about the impact of mutual fund flows on stock and bond prices. Many believe that the equity bull market of the l990`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 Granger causality and instrumental variables analysis. 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. In contrast, the magnitude of flows into both stock and bond funds are significantly affected by stock and bond returns. MUTUAL FUNDS AND STOCK AND BOND MARKET STABILITY 1. Introduction From 1990 through 1996 the S&P 500 stock index soared by more than 120 percent (from 329 on January 1, 1990, to 725 by early 1997), sending financial analysts in search of explanations for this unprecedented bull market. By 1996 conventional stock market yardsticks provided little comfort to investors: price-earnings ratios (of more than 20) approached the lofty levels seen right before the l987 stock market crash, and dividend-to-price ratios (of less than 2 percent) were at historical lows. The market to book ratio for the S&P 500 companies, another closely watched stock market indicator, also rose from about one in the early 1990`s to over 1.4 by 1996, a level not seen since right before the bear market of the 1970`s. Despite these signs of an overvalued stock market, mutual fund investors continued to pour money into stock mutual funds at an unprecedented pace. The assets of equity mutual funds went from $249 billion in January l990 to over $1.7 trillion by year-end l996, an increase of nearly 600 percent. During the entire 1984-96 bull market, stock prices and equity mutual fund net sales also exhibited a strong positive correlation.1 (See Figure 1) It is hardly surprising, therefore, that financial analysts and the financial press have pointed to equity mutual funds as the driving force behind the sustained run-up of stock prices. (See Wyatt (l996) and McGough (l997)). Their argument is simple and deceptively appealing: equity mutual fund growth manifests a greater demand by individuals to hold stock, and this “price pressure” must surely result in higher stock prices as more investors chase a relatively fixed supply of corporate equity. Indeed, from l990 through 1996 corporate “buy-back” programs actually reduced the amount of equity outstanding. The flipside of this view, which analysts also have recognized, is that a change-of-heart by 1 investors could result in widespread mutual fund redemptions sending stock prices plummeting. (See Wyatt (l997) and Kinsella (1996)). Each month analysts scrutinize mutual fund redemptions for signs that the stock market boom may be reaching its end. Notwithstanding these perceptions and fears, we know very little about the effect of mutual fund flows on either stock and bond prices -- markets in which mutual funds have become increasingly important. Despite the obvious correlation between mutual fund net sales and both stock and bond prices, this relationship is not sufficient to infer causality between mutual fund flows and asset prices. A positive correlation between fund flows and asset prices could exist for a number of reasons: increased equity mutual fund flows could in fact increase stock prices, an increase in stock prices could cause more people to buy equity mutual funds, or there may exist a two-way causality between fund flows and asset prices. Alternatively, both fund flows and asset prices could be caused by (or be positively associated with) other economic factors. For example, higher expected corporate profits could result in both higher stock prices and increased equity mutual funds sales as investors shift assets into equity mutual funds to obtain higher returns. This paper investigates the causal relationships between mutual fund flows and stock and bond prices. Specifically, we analyze the relationship between aggregate monthly mutual fund flows into stock and bond mutual funds and monthly stock and bond prices utilizing different econometric procedures designed to identify causal relationships. Equity mutual fund flows (sales, redemptions, and net sales) are examined for the 30-year period from January l961 through February l996, and bond mutual fund flows are examined for the 20-year period from January l976 through February l996. 2 2. Why Should Mutual Fund Flows Affect Asset Returns? Alternative Theories In an efficient market changes in stock prices (and returns) should reflect fundamental economic factors, such as changes in expected corporate profits or in interest rate levels (or the discount factor). Similarly, changes in bond prices (and returns) should reflect changes in expected interest rate levels. While stock and bond prices may stray from fundamental equilibrium values for short periods of time, such deviations can be expected to be random and short-lived, given the breadth and depth of U.S. financial markets. Thus, flows into or out of mutual funds, no matter how large, should arguably have no effect on equilibrium asset prices or returns independent of changes in market fundamentals. Suppose, for example, that a certain small segment of investors -- say those buying mutual funds -- decides to buy more equity (possibly for irrational reasons), even though there is no change in market fundamentals, but other segments of the investor population do not change their views about the fundamentals (or about expected corporate earnings and the appropriate risk premium.) While we would expect to observe an increased flow of funds into stock mutual funds, this increased demand for stock should quickly be met by a willingness to sell on the part of other stockholders (such as pension funds) who did not change their view of the fundamentals, thereby preventing a rise in stock prices. Mutual funds, after all, are only a small segment of the both stock and bond market: as of year-end l994 mutual funds held 12.2 percent of total outstanding corporate equity and about 14 percent of total U.S. government and corporate bonds.2 Pension funds are a much bigger player in both stock and bond markets than are mutual funds: at year-end l994 pension fund assets constituted nearly 28 percent of household financial assets, compared to about 7 percent for mutual funds.3 3 ... - tailieumienphi.vn