Asset Market Liquidity, Strategic Complementarity, and Bond Fund Flows

Abstract

A concave flow-performance relation in bond mutual funds induces market fragility concerns. Strategic complementarity of the investor's strategy arising from an illiquid bond market or investor self-selection could lead to such concavity. In highly liquid markets, like the Chinese bond market, we demonstrate that bond funds have a convex flow-performance relation. Additionally, using an exogenous shock to market liquidity that reduces the advantage of frontrunning other investors, we causally show that the sensitivity of outflows to poor fund performance significantly diminishes. Overall, the underlying asset market's liquidity is pivotal in explaining bond fund investors' strategic redemption decisions.

Keywords: Bond mutual fund, Flow-performance sensitivity, Market structure

JEL Classification: G11, G20, G23