Drivers of Flows-Performance Sensitivity in Mutual Funds

This paper examines the relationship between mutual fund performance and fund flows in Israel. Israel has a unique setting: Bonds are traded on a limit order book exchange, resulting in high liquidity. Using proprietary daily fund level data, I find a convex performance-flows relationship, meaning investors are more sensitive to good performance than to bad performance, in all three market segments of actively managed funds: government bonds, corporate bonds, and equity. This indicates that the first mover's advantage documented in US corporate bond mutual funds as a source of market fragility, which drives a concave performance-flows relationship, does not exist in Israel, and perhaps more generally in exchanges with a limit order book. I find that flows to passive funds are at minimum 40% less sensitive to performance in comparison to active funds, indicating that passive investments might have a moderating effect at times of financial stress, as flows to them are less procyclical than to active funds.