The Risk-free Rate and the Sensitivity of Mutual Fund Flows to Past Performance
42 Pages Posted: 28 Jun 2019 Last revised: 23 Mar 2021
Date Written: March 23, 2021
This study brings to light the new empirical fact that flows into US domestic equity mutual funds are less sensitive to past fund returns when the risk-free rate declines. In particular, a one-percentage-point drop in interest rates is associated with a decrease in the slope of the flow-performance relationship of around 18%. I demonstrate through a model of portfolio allocation with endogenous information choice that this novel finding is consistent with more privately informed fund investors when rates fall. Specifically, a lower riskless rate diminishes the opportunity cost of acquiring costly private information about a mutual fund, which leads to flows that are less dependent on publicly-available information (i.e., past fund performance). I provide empirical evidence for the model's mechanism by exploiting the cross-sectional implication that the weakening of the link between flows and past performance is more pronounced when information barriers are higher. With a fund class' retail clientele as proxy for information costs, I obtain ample support for this prediction. I also find that, in line with more intense information acquisition, flows are more positively related to future changes in fund performance when rates are low, with this effect similarly being stronger for retail fund classes.
Keywords: Flow-performance relationship of mutual funds, Asset allocation, Interest rates, Costly private information acquisition, Flows and future fund performance
JEL Classification: D82, D83, E44, G11, G23
Suggested Citation: Suggested Citation