Fund Flows in Rational Markets
by Francesco A. Franzoni, University of Lugano; Swiss Finance Institute
and Martin C. Schmalz, The Stephen M. Ross School of Business at the University of Michigan
September 19, 2013
We model the allocation of capital to mutual funds by rational risk-averse investors who are uncertain about both managers' skill and the funds' risk loadings. Uncertainty about risk loadings arises because fund portfolios are not continuously observed. Under these assumptions, investors learn more about alpha in downturns than in upturns. The reason is that, in downturns, the noise coming from the loading on aggregate risk is smaller, which increases the signal-to-noise ratio and thus simplifies the inference about skill. As a result, in downturns investors reallocate more wealth between funds and the flow-performance sensitivity is higher than in upturns. We test the model's cross-sectional and difference-in-difference predictions across fund types and market states and find supporting evidence.
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