Lipper Insight: Looking Again at Retail Investor Choices

In January of this year the author published in Lipper Insight the article, “Do U.S. Equity Mutual Fund Investors Really Chase Returns?” In this article the author explained why retail mutual fund investors prefer equity funds over bond funds or vice versa. Since questions are arising again about why retail investors seem to be preferring equity funds over bond funds, we are reprinting some excerpts from that article. Before the excerpts, however, we want to quote the Lipper weekly flows report of August 16, “Mutual fund (ex-ETF) investors’ interest in equity mutual funds remained intact; they injected a net $2.6 billion for the week (for the funds’ 32nd consecutive week of net inflows, bringing their year-to-date total to +$130.5 billion net). Domestic equity funds attracted net inflows for the 10th consecutive week, taking in $1.0 billion, while their nondomestic equity fund counterparts took in $1.6 billion and attracted net new money for the 11th consecutive week.”

The aim of a recent study by Lipper was to test competing theories about the related movement of mutual fund flows and stock market returns. The study’s results provided evidence for the hypothesis that stock market returns and mutual fund investors react in common ways to macroeconomic information, i.e., the study supported the information-response hypothesis. We found that mutual fund flows are better described by variables that proxy macroeconomic information than by stock market returns alone. In particular, the study showed that flows into equity funds are related to changes in dividend yield and the consumption-wealth ratio.

In outline, the study found:

• Mutual fund flows are related to “predictive” variables—in particular dividend yield—that proxy macroeconomic news.
• Mutual fund flows are also related to variables—other than dividend yield—that measure the state of the economy. An increase in the default spread or consumption-wealth ratio (both indicating riskier times) is associated with fund outflows.
• Overall, the predictive variables describe fund flows considerably better than do stock market returns alone. While stock market returns explain about 41% of the variation of unexpected mutual fund flows, the predictive variables explain up to 65%.
• The predictive variables can account for the correlation between fund flows and market returns.
• Market returns and mutual fund flows simultaneously react to macroeconomic news.

We define the predictive variables used in the study as variables that relate to present economic

REUTERS/Amr Abdallah Dalsh

activity or, more importantly, that relate to foreseen economic activity in the near future. The predictive variables in the study are: dividend yield, default spread (the difference between Moody’s Aaa and Baa returns), term spread (the difference between the yields of the ten-year and one-year Treasury bill), and the consumption-wealth ratio. The consumption-wealth ratio as its names implies is the ratio of consumption to total wealth. It summarizes individuals’ concerns about their future wages and asset returns.

The results of the study suggest an answer to why there were net outflows from U.S. equity funds for 2012, despite a good year-over-year increase in the stock prices of the major indices: First, mutual fund investors are predominantly private investors who are likely to be more severely affected by a recession than are their institutional counterparts. Moreover, within the group of retail investors, mutual fund investors are unusual. Mutual funds provide low-cost access to the equity market, enabling less-well-off investors to participate in the stock market. These investors, however, are presumably more affected by economic contractions and are thus more likely to sell stock funds when there is bad news about the economy.

To summarize, the results of our study suggest that mutual fund investors do not make (necessarily) “uninformed” investment choices or chase returns. Rather, they make investment choices based on their concerns about their future wages and future investment returns. This means that changes in the economy and changes in the equity premium affect fund choices—an observation certainly confirmed by many retail investors’ recent personal experiences.

And positive changes in the economy and the changes in the equity premium are a powerful part of why mutual fund investors “injected a net $2.6 billion for the week (for the funds’ 32nd consecutive week of net inflows, bringing their year-to-date total to +$130.5 billion net). Domestic equity funds attracted net inflows for the 10th consecutive week, taking in $1.0 billion, while their nondomestic equity fund counterparts took in $1.6 billion and attracted net new money for the 11th consecutive week.”