What drives mutual fund flows: profit or panic?

The purpose of this study is to examine the markettiming ability of mutual fund flows and how fund investors conduct asset allocation in response to market volatility. The paper compares the abnormal returns of net inflow funds with those of net outflow funds, and it explores the performance gap between them based on a model that incorporates both market return timing and market volatility timing. The asset allocation pattern of fund investors and its relation to market volatility are also investigated. This study finds that funds that receive net money inflows fail to earn riskadjusted abnormal returns, while funds with net outflows earn statistically significant negative abnormal returns. Neither the net inflow funds nor the net outflow funds show any ability to time the market return, but there is some evidence that net inflow funds exhibit an ability to time market volatility. Because cash holdings of the net outflow funds are much lower than that of the net inflow funds, it is concluded that the underperformance of net outflow funds is to an extent an asset fire sale. The study results show that fund investors on the whole are driven by market volatility, and they do not have an ability to time the market return. The results do not exclude the possibility that a small number of investors possess market timing skills. The study demonstrates the importance of funds' liquidity management through investor reaction to dynamic market conditions.