The Federal Open Market Committee (FOMC) of the Federal Reserve sets a target for the federal funds rate (FFR) in an effort to influence the money supply, and in turn the broader economy. This, along with more uncommon actions like quantitative easing, is monetary policy.
In a world of efficient markets, all known information is reflected in securities’ prices. Because monetary policy decisions reflect an economic outlook, market participants price anticipated FOMC moves before they occur. But the FOMC can act in a way contrary to the priced expectations; this is referred to as a monetary policy surprise.
My colleague, Sean Grover, a member of the investment strategy team at Buckingham and The BAM Alliance, furnished the following analysis of recent research that contributes to the literature on the link between the Fed’s monetary policy actions and mutual funds flows, as well as the potential risks to financial stability that may arise from it.
When Monetary Policy Surprises
In a 2016 working paper titled “Mutual Fund Flows, Monetary Policy and Financial Stability,” Ayelen Banegas, Gabriel Montes-Rojas and Lucas Siga study the effects of monetary policy surprises on mutual fund flows and investigate the possibility of a first-mover advantage in fund redemptions.
Given the large increase in mutual fund assets over the post-financial crisis period, the study was motivated by concern over potential disruptions to financial markets that might materialize if mutual fund flows are sensitive to monetary policy changes and/or mutual funds with less liquid assets experience redemption issues.
To conduct their study, the authors used a mutual fund data set from ICI to calculate funds’ monthly net new cash flows by investment category. The sample period is 2000 to 2014. Because a monetary policy surprise is not a directly observable variable, the authors used methods found in prior research to estimate such occurrences. These methods typically involve measuring shocks to the actual FFR. The measured surprises are then employed in a regression setting in an attempt to explain mutual fund flows, both at the aggregate level as well as at the investment strategy level.
The key results from the paper are summarized below:
- An unexpected increase in the FFR is associated with assets moving out of equity mutual funds and assets moving into bond mutual funds. An unexpected increase in the level of short-term interest rates may reflect near-term economic uncertainty.
- An unexpected increase in anticipated future changes to the FFR is associated with assets moving into equity mutual funds and assets moving out of bond mutual funds. An unexpected increase in the anticipated future short-term interest rate could be interpreted as reflecting a better-than-expected economic outlook.
- At an investment strategy level, high-yield bond mutual funds experience inflows/outflows that behave like equity mutual funds.
- Large outflows from bond mutual funds and less liquid equity mutual funds can affect the performance of these funds, which may create an economic incentive for runlike behavior. Bond mutual funds holding less liquid bonds are more susceptible than bond mutual funds that hold more liquid bonds, such as Treasurys and agency bonds.
A Direct Effect
The authors conclude that monetary policy can have a direct effect on mutual fund flows and suggest that this fact raises the potential for risks to financial stability. While this conclusion is important for investors to know, it should not conjure fear or keep anyone with a well-thought-out plan up at night. Portfolios built on academic evidence will hold a large number of securities across multiple mutual funds with globally diverse equities.
In addition, the portfolio as a whole should be relatively insulated if its fixed-income portion holds high-quality individual securities, such as Treasurys, FDIC-insured CDs and municipal bonds (only AAA/AA-rated and general obligation and essential service revenue bonds), or bond mutual funds that invest in high-quality and highly liquid bonds.
This will help protect the portfolio from risks arising from financial instability, as well as asset class and fund-specific risks. Furthermore, by following a strict rebalancing plan, investors won’t be selling at market lows and buying at market highs.
An evidence-based investor who adheres to their financial plan should be well-situated to weather the ups and downs brought about by monetary policy surprises, as well as the multitude of other surprises that so frequently make headlines.
This commentary originally appeared September 14 on ETF.com
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