Mutual Funds, Part II: Fund Flows and Security Returns

T his study is the second in a two-part analysis of the mutual fund industry. The first part (Fortune 1997, referred to here as " Part I ") examined the basic structure of the industry and discussed the historical relationship between mutual fund flows and returns on both short-term and long-term financial instruments. That study ended with a discussion of the role that momentum investing by mutual fund share-holders— buying in rising markets, selling in declines—might play in destabilizing financial markets. This study begins where Part I ended. The goal is to assess the historical evidence to see whether the interactions between mutual fund inflows, redemptions, and security prices are potentially destabilizing. Any analysis of the effect of mutual funds on financial stability should, in principle, be a comparative analysis in which performance of a financial system with mutual funds is compared to performance of a system with only direct ownership of securities. If we knew the structure of financial markets and the behavior of economic agents in each world, we could examine the effects of shocks on asset prices and financial flows, allowing us to determine whether specific asset markets are more or less disturbed by specific shocks in the " mutual fund " and " sans mutual fund " worlds. While some physicists subscribe to the " many universes " view of quantum theory, we do not have access to data from any universe other than our own. Our data come from a history in which mutual funds evolved in response to pressures inducing the decline of traditional financial institutions. Mutual funds played a very small role until the 1970s, before which ownership of financial instruments was dominated by commercial banks, thrift institutions, insurance companies, and pension funds. A comparison of financial market performance in that earlier world with performance in the modern financial system might shed some light on our fundamental question: Do mutual funds add to or reduce financial market volatility? But the results will not be definitive, for the