Where Does Money Flow? A Tale of Two Manager Abilities and The Role of Market Volatility

Abstract

This paper documents that investors differentiate mutual funds’ stock selection and market timing abilities. Moreover, market volatility has an opposite impact on investors’ responses to the two kinds of abilities. With an increase in market volatility, there are more inflows to funds with stock selection ability and fewer inflows to funds with market timing ability. Our empirical results are robust and cannot be explained by known determinants of mutual fund flow, including Morningstar ratings and several behavioral biases. We show that the findings are consistent with the prediction of a Bayesian learning model. All else equal, investors expect a lower probability of a fund possessing market timing ability while market volatility is high because the value added by the market timing ability increases with market volatility.

Keywords: Fund manager abilities, Market volatility, Fund flows, Investor sophistication

JEL Classification: G11, G23