Investment Flows: Retail Versus Institutional Mutual Funds
Ben-Gurion University of the Negev
October 12, 2015
The Journal of Asset Management, Forthcoming
In this study, I compare the fund selection criteria used by investors in retail mutual funds with the criteria of investors in institutional mutual funds. I show several differences in investment flow patterns between retail and institutional funds, which are consistent with differences in investor profiles of the two types of fund. More specifically, compared with investors of retail mutual funds, clients of institutional mutual funds use more quantitatively sophisticated criteria such as risk-adjusted return measures and tracking error, demonstrate stronger momentum-driven and herding behaviors, and are less sensitive to fund expense ratio.
Investment Flows: Retail Versus Institutional Mutual Funds – Introduction
Over the past decades, the mutual fund industry has grown considerably. Moreover, since the early 1990s, a new class of so-called institutional funds has emerged (James and Karceski, 2006).1 In contrast to retail funds, which focus on regular individuals, institutional funds primarily target institutional investors. As a result, the typical retail fund investor differs noticeably from the typical institutional fund investor in his level of financial sophistication, investment objectives, and search costs (Alexander et al. 1998; Del Guercio and Tkac 2002; James and Karceski, 2006; Palmiter and Taha 2008). Consequently, the two types of investors are likely to differ in terms of the criteria on which they base their investment decisions, and the resultant investment flow patterns of retail and institutional funds are likely to differ as well.
Previous studies of the determinants of mutual fund flows have established the importance of past performance (see, for example, Chevalier and Ellison, 1997; Gruber, 1996; Hendricks et al 1994; Ippolito, 1992; Sirri and Tufano, 1998; Ivkovich and Weisbenner, 2009; Del Guercio and Tkac, 2002; James and Karceski, 2006; Ferreira et al 2012). Others have shed light on the relationship between search costs and fund flows and on the influence of fund marketing and advertisement on flows (Sirri and Tufano, 1998; Barber et al 2005). Some studies have also shown that the momentum exposure of a fund has a significant influence on its flows (see, for example, Nofsinger and Sias, 1999; Jegadeesh and Titman, 1993; Grinblatt and Keloharju, 2001; Froot and Teo, 2004; Sias, 2004; Gallo et al 2008). However, few studies have distinguished among flows of funds targeting different types of investors. Meanwhile, the growing proportion of institutional funds –in terms of both the number of funds and the volume of assets under management – makes the recognition and understanding of those differences increasingly important.
In this paper, I study determinants of mutual fund investment flows separately for retail funds and for institutional funds, examining how fund selection criteria differ between investors of the two types of funds.
Conducting the investigation using the complete universe of diversified U.S. equity mutual funds for the period January 1999 to December 2012, I find a number of differences in investment flow patterns between retail and institutional funds. First, customers of institutional mutual funds are more strongly influenced by return measures that are considered to be sophisticated, such as Jensen’s alpha and other measures of risk-adjusted return, whereas investors of retail funds are more sensitive to non-sophisticated measures, such as raw return. This observation is consistent with differences in profiles of the two types of investors. In fact, individual investors are considered to be unsophisticated in financial issues, as they are mostly unaware of the basic characteristics of the funds they invest in, do not take into account the risks and costs associated with their fund investments, and chase past returns (Capon et al 1996; Alexander et al 1998; Palmiter and Taha, 2008). In contrast, institutional investors are commonly considered to be more sophisticated: when making investment decisions, they rely more on quantitatively sophisticated fund performance evaluation measures (Del Guercio and Tkac, 2002; James and Karceski, 2006). Moreover, institutional investors are often professionals specializing in investment management. Furthermore, the economies of scale provide institutional investors a better access to the services of professional experts, reduce considerably their search costs (see, for example, Sirri and Tufano, 1998), and allow them broader diversification opportunities.
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