A study of mutual fund investors' asset allocation decisions

This dissertation consists of three chapters. The first chapter studies the relation between monthly mutual fund cash flows and market performances. In this chapter, we document strong evidence that fixed-income mutual fund investors over the period of 1984–1998 and mutual fund investors over the period of 1963–1983 follow positive feedback trading strategies at the aggregate level. Our empirical results indicate that those fund investors chase past performance in a relatively long term horizon such as six months or twelve months and place monotonically increasing weights on the more recently realized market returns. We also find that market returns are negatively correlated with lagged fund flows, for both equity funds and bond funds. The negative relation between returns and lagged fund flows may ease the concern about fund flows destabilizing the market.; The second chapter examines the relation between market volatility and monthly mutual fund cash flows. We find that stock fund investors respond negatively to concurrent and past long term market volatility. Stock fund investors' volatility timing behavior explains why fund managers decrease market exposure during periods of high market volatility. We also find that the negative relation between stock fund flows and market volatility is not entirely driven by the persistency of volatility over time or the relation between risks and returns. Using semi-variance of daily stock market returns, we find no evidence that investors are only concerned about downside volatility. We also find that stock fund flows in our sample period have strong positive impact on the subsequent market volatility.; The third chapter studies the relation between mutual fund investors' asset allocation decisions and changes in business conditions. We find that mutual fund investors change their asset allocations between stocks and bonds in reaction to business conditions tracked by changes in expected stock market returns. They tend to allocate more into stock funds during the peak of a business cycle when expected returns are low. We also find that variables that capture the changes of real macroeconomic activities have strong impact on mutual fund investors' asset allocations between stocks and bonds. During expansions of the economy, they tend to invest more into stock funds than into bond funds. During recessions of the economy, they tend to invest less into stock funds.