Endogeneity in the Mutual Fund Flow-Performance Relationship: An Instrumental Variable Solution

47 Pages Posted: 29 Jan 2021

See all articles by David A. Rakowski

David A. Rakowski

University of Texas at Arlington

Ehab Abdel-Tawab Yamani

Chicago State University

Date Written: December 10, 2020

Abstract

We use an instrumental variables (IV) approach to examine the effects of dynamic endogeneity when estimating the relationship between mutual fund flows and performance. Unlike the one-stage estimation approach commonly used in prior research, the IV approach allows us to address reverse causality between flow and performance. Through rigorous exclusion tests, we conclude that fund media coverage, risk ranking, and management structure win in a horse race as exogenous instruments for fund flow, while the fund turnover ratio and institutional share perform best as instruments for fund performance. We then demonstrate that endogeneity bias leads to inaccurate inferences in one-stage estimates, as evidenced by the reversals of the signs of flow and performance coefficient estimates when we switch to the IV approach. We find that careful attention to model specification allows us to resolve several widespread inconsistencies in the literature that were likely driven by model misspecification.

Keywords: mutual funds, fund flows, portfolio performance, endogeneity, instrumental variables, 2SLS, reverse causality, model specification, flow-performance relationship

JEL Classification: G11, G23, C36, C58

Suggested Citation

Rakowski, David A. and Yamani, Ehab Abdel-Tawab, Endogeneity in the Mutual Fund Flow-Performance Relationship: An Instrumental Variable Solution (December 10, 2020). Available at SSRN: https://ssrn.com/abstract=3746457 or http://dx.doi.org/10.2139/ssrn.3746457

David A. Rakowski (Contact Author)

University of Texas at Arlington ( email )

Box 19449 UTA
Arlington, TX 76019
United States

Ehab Abdel-Tawab Yamani

Chicago State University ( email )

College of Business
9501 S. King Drive / BHS 411
Chicago, IL 60628
United States
773-995-3954 (Phone)

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