Academic journal article Federal Reserve Bulletin

Mutual Funds and the U.S. Equity Market

Academic journal article Federal Reserve Bulletin

Mutual Funds and the U.S. Equity Market

Article excerpt

Eric M. Engen and Andreas Lehnert, of the Board's Division of Research and Statistics, prepared this article with the assistance of Richard Kehoe.

Mutual funds have become an important intermediary between households and financial markets, particularly the equity market. By providing liquid, low-cost shares in a diversified portfolio of financial assets selected by professional money managers, mutual funds have enabled an increasing number of households to enter financial markets. Indeed, about half of all U.S. households currently own shares in a mutual fund.

Since 1990, total mutual fund assets have increased nearly sevenfold, and the assets of mutual funds that invest in stocks have grown even more, expanding nearly twentyfold. Over the same period, mutual fund assets have come to account for a larger share of household wealth. Moreover, a greater proportion of U.S. households now own stock, in large part because of their investments in mutual funds. Much of this growth has come in households' retirement assets, as developments in pension plans and other tax-preferred retirement accounts have increasingly made it possible for households to control more of their retirement asset portfolios--and households have tended to invest a significant portion of their retirement assets in mutual funds.

As the popularity of mutual funds as an investment vehicle has grown, so too has their importance in financial markets. Mutual funds currently hold about one-fifth of publicly traded U.S. corporate equities. Thus, the investment behavior of mutual fund shareholders could, in theory, influence equity market prices. For example, if fund shareholders were to request large redemptions from their accounts when faced with a sharp decline in equity prices, mutual fund managers might be forced to sell some of the funds' equity holdings in the slumping market, exacerbating the decline. In recent years, however, mutual fund shareholders as a group have not tended to flee from their equity investments when confronted with sharp temporary drops in equity prices. Indeed, there is some evidence that shareholder restraint in requesting redemptions has been greater recently than during earlier periods of market turbulence.

Mutual fund investors could also distort equity prices if their enthusiasm for investing in mutual funds were to go beyond general market assessments of fundamentals and tolerance for risk, pushing equity prices temporarily above the level that other equity market participants would tend to settle on. We present evidence, however, indicating that mutual fund investors, like other market investors, have been trading primarily in response to new information and other factors that influence the value of stocks. Thus, in general, we find little evidence that mutual fund investors have been a destabilizing force in the U.S. equity market in recent years.

GROWTH OF MUTUAL FUND ASSETS

Assets under management at mutual funds have grown substantially over the past fifteen years (chart 1).(1) At the end of August 2000, mutual funds held about $7 1/2 trillion in assets, making them the largest type of financial institution (as measured by assets under management), even larger than commercial banks. Most of the recent growth has come in assets invested in equity mutual funds, that is, mutual funds that specialize in investing in the shares of publicly traded firms. At the end of August 2000, equity funds held more than 60 percent of all mutual fund assets, or more than $4 1/2 trillion. The next largest group--money market mutual funds, which invest in very short term liquid assets such as commercial paper and Treasury bills--held less than $2 trillion in assets. Bond funds--which invest in corporate, Treasury, government agency, and foreign bonds--and hybrid funds--which invest in a mix of stocks and bonds--held about $1 trillion in assets combined.(2)

[Graph omitted]

Mutual funds that invest primarily in the shares of corporations based in the United States are by far the largest type of equity mutual fund (chart 2). …

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