The (Bad?) Timing of Mutual Fund Investors

This paper provides a new look at the timing of mutual fund investors. We re-examine the relationship between investors' aggregate net flows into and out of the funds and the returns of the funds in subsequent periods. The negative relationship that we find (using monthly data of aggregate US equity mutual funds in the years 1984-2003 and a statistical test based on bootstrapping of returns) causes mutual fund investors, as a group, to realize a lower long-term accumulated return than the long-term accumulated return on a 'buy and hold' position in these funds. The 'bad' performance of mutual fund investors can be explained either by 'behavioural explanations' such as investor sentiment or by 'rational market explanations' that are based on time-varying risk premiums. We present a simple overlapping-generation model which predicts a negative relationship between flows and subsequent returns. It is assumed that flows into and out of funds are not related to information about future cash flows (dividends), but are caused by changes in other factors affecting the demand for stocks. Hence, a positive (negative) net flow in a given month implies a positive (negative) price change in the same month, but also lower (higher) expected future returns. We show that in each month the change in the expected future returns may be small (relative to the return variance), but the accumulated effect of these changes may be significant. This result may explain why previous studies, using monthly data of flows and returns in either simple regression models or VAR, could not have significantly detected the monthly change in the expected future returns even in a 15-year sample.