Asian Review of Financial Research Vol.31 No.1 pp.83-115
Validity of Fund Flows as a Measure of Investor Sentiment
Key Words : Fund Flows,Investor Sentiment,Fund Transfer Index,Asset Allocation,Market Return Prediction
This paper examines how fund flows predict subsequent market returns, especially focusing on the validity of using fund flows as a measure of investor sentiment for the Korean financial market. For this purpose, we use a variety of fund flow indicators. In contrast to the previous literature in Korea, which has solely analyzed the fund new sales and redemptions, this article develops a fund transfer index, i.e., the shifts between equity funds and bond funds, and also uses it as a proxy variable for investigating the relationships between fund flows and market returns. Another contribution of the paper is that, based on the newly developed indicator, we investigate whether the fund transfer index has a significant impact on market returns. Therefore, this study can be expected to fill the gap in the literature which has mainly dealt with the relationships between equity fund flows and stock returns and between bond fund flows and bond returns. Against this backdrop, the paper attempts to address three research questions in order. First, we examine whether various fund flow indices such as fund-new-sales and redemptions-indices and fund-transfer-indices for equity and bond funds in Korean markets could be viewed as a relevant measure for investor sentiment. It is rather well documented in the literature that investor sentiment affects market returns. Here, a more important question is how to measure investor sentiment and quantify its effects. Generally speaking, investor sentiment is the overall attitude of investors toward future cash flows or fundamentals and the feeling or tone of investors as revealed through the activity and price movement of the securities traded in markets. Thus, the better sentiment measure should quantify the biases of market prices which are not explained by economic fundamentals. More specifically, positive sentiment pushes asset prices to extraordinarily higher levels in the short run but leads them to equilibrium in the long run. The underlying key assumption here is that individual investors are often noise traders potentially because they are less informed and less capable in information processing than institutional investors. Having said that, this paper verifies those fund flow indices could satisfy the prerequisites for a relevant measure of investor sentiment in the Korean financial markets. Second, by conducting the lead-lag analyses, we examine the relationships between fund flows and financial asset prices. That is, the paper checks whether contemporaneous flow indices and the accumulated flow indices affect market returns. In this process, we verify whether fund flows could measure investor sentiment and whether they could predict market returns originated from mispricing. Third, this article analyzes whether fund transfer flows have a significant effect on excess returns in equity returns and bond returns, respectively. This is in contrast to the previous studies which have focused only on the relationships between equity fund flows and excess returns in stock markets. Our main findings can be summarized as follows. First, we find that fund flows in Korea fail to satisfy the prerequisite conditions for investor sentiment, which is ‘short-run upsurge and long-run reversal' pattern. This finding highlights the limitations of previous domestic studies that measure investor sentiment with fund flows. Based on this result, we argue that the previous studies, which use fund flows as a proxy for investor sentiment, have a consequential problem in common due to immature fund markets. This conjecture still seems to be consistent with the extant literature which points out the instability of fund flows and structural changes around the fund markets of Korea. Second, we find that fund flows have a substantial prediction power on market returns. For instance, while the equity fund net inflow index (denoted to NEAR) can predict stock market excess returns over three to six month horizons, the bond fund net inflow index (denoted to NBAR) and the fund transfer index (denoted to FAR) can predict bond market returns over one to six months ahead. Moreover, our finding confirms that the inclusion of the fund transfer index along with other economic variables could significantly increase the prediction power, measured in Adjusted R-squared, on market returns. Last but more importantly, we firstly document that fund transfer flows between equity funds and bond funds could be an useful indicator to explain excess returns in the Korean stock and bond markets. Together with the second finding, this result implies that the fund transfer between equity and bond funds has information regarding the asset allocation of investors, reflecting the prospect on future market conditions. On the contrary, the fund flows not including the fund transfer information contain only on the long-term savings and withdrawals.