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Inflation and Equity Mutual Fund Flows ∗
Srinivasan Krishnamurthy† Denis Pelletier‡ Richard Warr §
November 2014
Abstract
We document a negative relation between inflation and aggregate equity mutual fund flows and
hypothesize that this relation is partly due to inflation illusion on the part of investors. Inflation
illusion occurs when investors assign lower equity valuations because they fail to incorporate the
effect of inflation into their estimates of nominal growth rates. Our results are robust to controls
for alternative explanations such as the proxy hypothesis which states that inflation proxies for
poorer future real cash flow growth and the risk hypothesis which states that periods of higher
inflation are associated with higher equity risk premia.
JEL Classifications: E21, G11, G23
Keywords: Mutual Funds, Fund flows, Inflation illusion, Equity valuation
∗Contact author’s email: [email protected]. The authors would like to thank Charles Knoeber, Doug Pierce andseminar participants at North Carolina State University for many useful comments and suggestions.†Poole College of Management, North Carolina State University, Raleigh NC 27695. E-mail: [email protected].‡Poole College of Management, North Carolina State University, Raleigh NC 27695. E-mail: [email protected]§Poole College of Management, North Carolina State University, Raleigh NC 27695. E-mail: [email protected]
The mutual fund industry in the United States is large, with assets under management in 2013
amounting to over $10 trillion.1 A large literature has examined various aspects of equity mutual fund
performance such as the level and persistence of their performance, and whether certain fund/manager
characteristics are associated with superior performance.2 In addition researchers have studied the
determinants of the size of the mutual fund industry across the world and conclude that it is affected by
a country’s regulatory framework and other market characteristics.3 Researchers have also examined
the factors that affect the inflow of new money into individual funds and the impact of fund flows on
fund performance.4
While there is much work examining flows at the individual fund level, research examining the
aggregate flow of money into (and out of) equity mutual funds as a group is sparse. Factors affecting
flows into individual funds need not necessarily translate into a similar effect on aggregate fund flows.
For example, if an individual mutual fund decreases the amount of fees charged to investors, it could
experience an increase in fund inflows. However, if such flows are mainly due to investors moving their
investments from more expensive funds to this lower cost fund, such an exchange would not affect
fund flows at the aggregate level. We also know little about how macroeconomic factors influence
aggregate asset allocation decisions. This lack of knowledge exists despite the popular press frequently
commenting on such aggregate flows.5 In this paper, we address these questions by examining the
role that one macroeconomic variable – inflation – plays in determining the flow of money into equity
mutual funds at the aggregate, economy-wide level.
We focus on the effect of inflation on equity fund flows for several reasons. First, compared to
many other macroeconomic variables such as the default premium, the concept of inflation is relatively
easy for investors to comprehend since they regularly deal with the effects of inflation in other areas
of their day to day life. Second, news about inflation is frequently discussed in the media, suggesting
that investors have access to ample information about inflation. For example, a casual search for
the appearance of the term “inflation” in articles published in the New York Times during January
1Flow of funds accounts of the United States, Board of Governors of the Federal Reserve System.2Researchers have studied whether fund performance is related to the level of the fund’s industry concentration
(Kacperczyk, Sialm, and Zheng (2005)), the extent to which the portfolio holdings deviate from a passive index (Cre-mers and Petajisto (2009)), board connections (Cohen, Frazzini, and Malloy (2008)), the fund manager’s educationalbackground and age (Chevalier and Ellison (1999)), etc.
3See for example Khorana, Servaes and Tufano (2005).4See, e.g., Sirri and Tufano (1998), Zheng (1999), Edelen (1999), Barber, Odean, and Zheng (2005), Bergstresser and
Poterba (2002), Berk and Green (2004), Huang, Wei, and Yan (2007), Spiegel and Zhang (2013).5“Investors bolt from equity funds into bonds”, Wall Street Journal Online, February 6, 2014.
1
2009-December 2013 resulted in more than 2,500 hits, or about eleven articles per week. There were
only three articles that mentioned the phrase “default premium” during the same time period. While
some articles may pertain to other uses of the term “inflation” (e.g., grade inflation), a casual perusal
of the title of the first several articles suggested that they are primarily about price inflation in the
economy.6 More importantly, prior literature (discussed in more detail later) has documented an
important role for inflation in affecting stock prices. Researchers have documented a negative link
between inflation and stock returns (e.g., Bodie (1976), Fama and Schwert (1977)). Hence, if investors’
expectations of future stock returns are affected by inflation (whether in a rational manner or not),
then inflation could have a first-order effect on their asset allocation decision, i.e., their decision to
invest in equities.
It is not clear a priori that inflation should have an effect on the asset allocation decision of
investors. Standard portfolio theory suggests that if the mutual fund separation theorem holds,
then all investors will hold portfolios consisting of the risk-free asset and a portfolio of risky assets,
the relative weights depending on the investors’ risk aversion. Investors would achieve their preferred
asset allocation by varying the weights invested in the risk-free asset and the risky portfolio. However,
the composition of the risky portfolio itself (i.e., the mix of risky assets such as stocks and bonds)
would be identical across all investors. Further, given a vector of expected returns and the associated
covariances, the mix of stocks and bonds should not change. However, if news about inflation causes
investors to reassess their estimates of expected returns, then they could change the mix of risky
assets in their portfolio. In particular, if inflation news causes them to perceive particular assets
as overpriced (i.e., they expect negative risk-adjusted returns or “alpha” in the future), it may be
optimal to reduce the weight on such assets in their portfolio.7
The primary hypotheses that we test are (a) does inflation, in the aggregate affect investment in
equity mutual funds, and (b) is this relation primarily the outcome of inflation illusion on the part of
mutual fund investors? If, as prior research finds (e.g., Bodie (1976), Fama and Schwert (1977)), high
inflation is associated with lower stock returns, then we expect investors to respond by moving their
assets away from equities, leading to an outflow of funds from equity mutual funds. One possible
6A similar search during 1989-1993 resulted in over 1,000 articles that mention inflation and zero articles that mentionthe phrase “default premium”.
7Pastor (2000) (page 181) states that when investors have prior beliefs that some assets have a mispricing alphawithin the CAPM, “... one should invest (disinvest) in any asset whose α is positive (negative), since combining theasset with the market portfolio increases the portfolio’s Sharpe ratio.” See also Ferson and Lin (2014).
2
reason for such an effect could be inflation illusion on the part of investors.
Inflation illusion (also called money illusion) occurs when investors confuse nominal and real
growth rates. Under the inflation illusion hypothesis, Modigliani and Cohn (1979) argue that investors
in the stock market incorporate the effect of inflation into their estimates of discount rates but not
into their estimates of long-term cash flows. Hence, during times of high inflation, investors discount
unchanged real cash flows at the higher nominal discount rate, leading them to assign lower intrinsic
value to stocks. Ritter and Warr (2002) and Cohen, Polk and Vuolteenaho (2005) empirically show
that inflation illusion significantly affects stock returns. The expectation of lower stock returns (or
a negative perceived alpha) would lead investors to reallocate assets away from equities and into
other assets such as money market securities and bonds. Our investigation seeks to tie together the
recent work that has examined the impact of inflation illusion in the stock market with the fund flow
literature to examine the impact of inflation on aggregate flows into equity mutual funds.
In addition to the inflation illusion explanation, we consider two other competing explanations
for why investors may shun stocks during periods of higher inflation. First, Fama’s (1981) proxy hy-
pothesis argues that the negative link between inflation and stock returns is a proxy for the positive
association between stock returns and real economic activity. He argues that the more fundamental
negative relation between inflation and real activity results in an observed negative association be-
tween inflation and stock returns. All else equal, stock market investors would respond to the lower
stock returns by reallocating their assets away from stocks and into other assets such as bonds and
cash (risk-free investments). Second, the risk hypothesis (see for example Brandt and Wang (2003)
and Bekaert and Engstrom (2010)) suggests that periods of high inflation coincide with high levels of
economic uncertainty and/or high levels of risk aversion. Higher risk aversion on the part of investors
would lead to a reallocation of assets away from more risky securities (i.e., equities) and into less
risky securities (bonds and money-market instruments). We do not consider a third explanation that
argues that the adverse effect of inflation on share prices is due to taxes (e.g., Feldstein (1980)).
Rydqvist, Spizman, and Strebulaev (2013) argue that tax incentives are the primary factor that has
affected the holdings of stocks in retirement plans, including mutual funds and pension funds. But
Thaler (1999) and Agnew, Balduzzi, and Sunden (2003) suggest that investors rarely trade or actively
rebalance their pension portfolios, suggesting that the tax-sensitive component of mutual fund assets
(that is invested in mutual funds via retirement plans) is less likely to be adjusted in response to
3
inflation. Hence we do not consider the tax explanation in our analysis.
We use data on mutual fund flows from the Flow of Funds Accounts of the United States issued
by the Board of Governors of the Federal Reserve System over the years 1976 to 2013 (flow of funds
data, hereafter) to conduct our analysis. Specifically we test whether inflation and empirical proxies
for inflation illusion have a first order effect on aggregate equity mutual fund flows after controlling for
other factors (e.g., level of economic activity, risk aversion, prior stock market performance, etc.) that
may affect such fund flows. We caution that we are not postulating that every investor behaves in
such a manner. Rather, our hypothesis asserts that if a sufficiently large number of investors behave
as predicted, then we should observe a measurably large effect of inflation (or inflation illusion) on
equity fund flows. We also note that since we are examining aggregate fund flows, variables that
characterize individual mutual funds such as their performance, fees and expenses and fund family
association are not viable explanatory factors.
We first investigate whether inflation has an effect on the flow of funds into equity funds. We
find that the level of inflation is negatively correlated with aggregate flow to equity mutual funds.
This result is both statistically and economically significant. Our point estimates suggest that a one
standard deviation increase in inflation is associated with a 0.45% decrease in the rate of equity mutual
fund flows in the next quarter (deflated by the US GDP). In dollar terms, this decrease translates to
roughly $27 billion fewer dollars flowing to equity funds.8
Second, we test whether the effect of inflation on equity fund flows is due to the inflation illusion
hypothesis, after including controls for two other potential explanations for the inflation - asset
flows relation (the proxy and the risk explanations). We consistently find that proxies for inflation
illusion are negatively related to aggregate inflows into equity mutual funds in the subsequent quarter.
Our results are not artificially driven by prior stock market returns driving the subsequent asset
reallocation since we explicitly control for prior returns in our analysis. Our results continue to hold
even after we include controls for the proxy and the risk explanations.
We extend our analysis to examine the impact of inflation illusion on flows into other asset classes -
bond mutual funds, money market funds, and bank deposits. We expect the impact of inflation illusion
on flows into these other asset classes to be weaker since the nominal cash flows received by investors
in these securities are fixed and unlike equity cash flows, do not need adjustment for the effects of
8The mean quarterly flow into equity funds is about $60 billion.
4
inflation. Further, investors may view them as substitute investments and respond to inflation by
moving money away from equity mutual funds and into bond/money market mutual funds and/or
deposits. We find a negative or no link (depending upon the specification) between inflation illusion
and flows to bond funds and money market funds. However, we find that flows into bank deposits
is positively associated with inflation illusion. This finding suggests that when investors respond to
inflation illusion by reducing flows to equity mutual funds, the money is reallocated primarily into
relatively safe bank deposits. The impact on flows into bond and money market funds is negligible.
We believe that to the best of our knowledge these results are new to the literature. We are aware
of two other papers that examine aggregate fund flows into mutual funds. Kamstra, Kramer, Levin,
and Wermers (2012) find that there is a seasonal effect in mutual fund flows. Specifically, they find
that funds flow away from equities and into money market and government bond funds in the Fall, and
back to equities in the Spring. They argue that such behavior is consistent with a seasonal pattern
in investor’s appetite for risk, with investors being more averse to financial risk in fall/winter rather
than in the summer. Chalmers, Kaul, and Phillips (2011) examine whether economic conditions affect
the aggregate asset allocations of U.S. mutual fund investors and find that they do. However, neither
of these papers examines whether inflation and inflation illusion affects how investors allocate their
wealth to equities, which is the main issue tackled in this paper.
To summarize, our results suggest that the inflation illusion hypothesis has a first order effect on
aggregate flows into equity mutual funds and is able to explain why high inflation induces mutual
fund investors to reduce flows to equity mutual funds and into safer assets such as bank deposits. At
a broader level, our results may at least partially explain the finding that periods of high inflation
depress stock prices and hence are followed by higher returns (as documented in, for example Campbell
and Vuolteenaho (2004)). The selling pressure arising from reallocations away from equity mutual
funds could temporarily depress equity prices to below fundamental value, leading to superior future
returns. While suggestive, we leave a more complete examination of this effect to future research.9
The rest of the paper is organized as follows. Section 1 provides a brief overview of the related
literature and develops the specific hypotheses that we test in the paper. Section 2 discusses the data
and methodology and Section 3 presents the results in the paper. Section 4 concludes the paper.
9Prior research (e.g., Warther (1995), Edelen and Warner (2001)) finds that aggregate fund flows affect returns, butdoes not examine whether fund flows arising due to the effects of inflation illusion are the main driving force for suchan effect.
5
1 Literature review and hypotheses
In this section we discuss the relevant literature and develop our hypotheses. First, we provide a brief
overview of the literature that examines the effect of inflation on equity values and its expected effect
on the investors’ aggregate equity market investments. We then discuss inflation illusion as a possible
explanation for investors’ reaction to inflation. We also briefly review two other possible explanations
– Fama’s (1981) proxy hypothesis and the risk hypothesis – that could explain why investors may
alter their asset allocations in response to inflation. Finally, we also briefly review the literature that
examines inflows into mutual funds, both at the individual fund level and at the aggregate level.
1.1 Inflation and equity values
The negative relation between inflation and equity values has been well-documented. For example,
Fama and Schwert (1977) find that common stock returns are negatively related to expected inflation.
The negative relation is also observed in the Fed Model (not endorsed by the Fed) that is commonly
used by practitioners. The Fed model postulates a positive relation between the earnings yield on
stocks and the yield on long term government bonds, even though such a relation is troubling from a
theoretical viewpoint because stocks are claims on real cash flows and their values should be immune
to changes in the level of inflation. In any case, if stock returns are negatively associated with
inflation, we would expect investors to react by moving their assets away from equity mutual funds
when inflation levels are high.
Our first hypothesis tests this relation. Specifically, we test whether the aggregate flows into stock
mutual funds are correlated with inflation. If high inflation levels indicate lower stock returns, we
expect equity mutual funds to experience fund outflows as investors reallocate their assets away from
stocks, leading to a negative link between inflation and equity fund flows.
Hypothesis H1: When the level of inflation is high, investors will reduce their investment in
equities, resulting in a negative correlation between inflation and equity fund flows.
In the following two subsections, we discuss possible reasons for the relation between inflation
and equity returns - the inflation illusion hypothesis, and two alternative explanations, the proxy
hypothesis and the risk hypothesis.
6
1.2 The inflation illusion hypothesis
Inflation illusion arises when investors confuse nominal and real returns when valuing economic op-
portunities. In one of the earliest works on inflation illusion and stock prices, Modigliani and Cohn
(1979) argue that inflation illusion results in misvaluation of stock prices. They specifically argue that
investors make mistakes when valuing stocks in the presence of inflation, confusing nominal and real
growth rates. They correctly interpret higher inflation as indicating a higher discount rate in their
valuations, but do not incorporate the higher inflation rate into their estimates of (higher) nominal
growth. This capitalization rate error is, in effect, the act of valuing a real cash flow using a nominal
discount rate. Equivalently, investors may correctly use nominal discount rates to discount nominal
cash flows, but fail to adjust the nominal cash flows upwards to reflect the higher inflation.10
Following Modigliani and Cohn (1979), several authors have found support for the basic hypothesis
that investors suffer from inflation illusion and undervalue stocks during periods of high inflation (e.g.,
Cagan (1982) and Cohn and Lessard (1981)). Ritter and Warr (2002) undertake a comprehensive
study of the Modigliani and Cohn (1979) hypothesis and examine the impact of inflation on the Dow
30 stocks over a twenty-year time period. They find that stocks are undervalued during periods of
higher expected inflation and that this undervaluation is correlated with future returns. Campbell
and Vuolteenaho (2004) use the Campbell and Shiller (1988) model to decompose the D/P yield into
its underlying discount rate and dividend growth components to examine the effect of inflation on
stock prices. They show that high inflation leads to stock market underpricing and low or negative
inflation leads to overpricing.
Researchers have examined whether such an inflation illusion also exists in other related areas.
Cohen, Polk and Vuolteenaho (2005) examine the effect of inflation illusion on the ability of the
CAPM to predict returns. They find that inflation illusion causes the market’s subjective expectation
of the equity premium to deviate systematically from the rational expectation. They document that
stock market investors suffer from inflation illusion, and conclude that “...to the extent that investors
perceive a benefit from valuing stocks using nominal quantities, they should pay more attention to
expected inflation when forecasting future nominal cash flows.” Chordia and Shivakumar (2005) find
that inflation illusion causes firms whose earnings are positively related to inflation to be undervalued
because investors don’t incorporate the effect of inflation when estimating future earnings. Focusing
10Chordia and Shivakumar (2005) find that lagged inflation significantly predicts subsequent corporate earnings.
7
on asset bubbles, Chen, Lung, and Wang (2009) find that while inflation illusion can explain the level
of mispricing, it does not explain the volatility of mispricing. Finally, Brunnermeier and Julliard
(2008) test the effect of the Modigliani and Cohn hypothesis on house prices and conclude that home
buyers suffer from inflation illusion.
If investors in general suffer from inflation illusion and are unable to accurately incorporate the
effects of inflation into their cash flow estimates and valuation, could sophisticated intermediaries not
resolve the problem by providing accurate forecasts that take the impact of inflation into account?
For example, equity research analysts provide earnings forecasts to stock market investors. If they
are sophisticated intermediaries, they could correctly incorporate inflation into their cash flow and
earnings forecasts and thus counteract an investor’s bias. The evidence however, does not support
this conjecture, as Sharpe (2002) finds that analysts suffer from inflation illusion in their forecasts and
that these errors are impounded into the P/E ratio. Furthermore, Basu, Markov, and Shivakumar
(2010) examine financial analysts’ forecasts for individual stocks and conclude that their evidence is
consistent with analysts not fully incorporating inflation-related information into their forecasts.
In summary, the inflation illusion hypothesis predicts that high inflation will result in the under-
valuation of equities. The lower estimate of value would lead investors to move their assets away from
equities, resulting in an outflow from equity mutual funds.
Hypothesis H2: Under the inflation illusion hypothesis (as in Modigliani and Cohn (1979)), there
will be a negative relation between equity fund flows and measures of irrational mispricing by investors
(mispricing induced as a result of inflation illusion).
1.3 Other explanations for the inflation - equity value relation
Several other mechanisms have been suggested that could explain how inflation affects stock prices
and hence, affects flows into equity funds. While the inflation illusion hypothesis assumes investor
irrationality, we consider two alternative explanations that are grounded in rational investor behavior.
The first explanation is the so-called proxy (or growth) hypothesis articulated by Fama (1981).
Fama argues that high inflation does not have a direct effect on equities, but works through an indirect
mechanism as a proxy for slower real economic growth. Briefly, a decline in expected real activity
would lower the demand for money, in real terms. Holding the nominal money and the interest rate
8
constant, this decline in demand for money would result in an increase in prices, i.e., higher inflation.
If inflation serves as a proxy for weaker future economic conditions and there is a positive association
between real activity and stock prices (i.e., the stock market rationally capitalizes real economic
activity), then we would expect higher inflation to be associated with lower stock returns. However,
this relation does not imply that higher inflation causes lower stock returns. Rather, the fundamental
negative link between inflation and real activity results in a negative link between inflation and stock
returns since the stock market rationally capitalizes the expected (lower) future real activity. In such
a case, investors may rationally reduce their exposure to equities during periods of high inflation.11
A link between inflation and equity values could also exist if periods of higher inflation are associ-
ated with greater economic uncertainty and high levels of risk aversion (the risk hypothesis). Brandt
and Wang (2003) formulate a model in which aggregate risk aversion is affected by inflation news, and
present empirical evidence to support their argument. They suggest that a possible behavioral reason
could be “...the anxiety consumers expressed about inflation in the recent survey of Shiller (1996).”
If consumers (who could also be investors) fear rigid nominal wages in the face of higher inflation,
they could become more risk averse during inflationary periods. Bekaert and Engstrom (2010) also
argue that risk aversion could increase during inflationary periods. During recessionary periods, the
economic uncertainty may induce high risk aversion on the part of investors. Further, if inflation
is also high when the economy is weak, we would observe a positive link between inflation and risk
aversion. As a result, investment classes which derive much of their value from future (uncertain)
cash flows are likely to be significantly impacted by this uncertainty. From an equity valuation point
of view, the higher risk aversion associated with high inflation periods would manifest itself in the
form of higher equity risk premiums and lower equity values. Again, we would expect mutual fund
investors to reduce their allocations to equity mutual funds in the face of lower (expected) equity
values, until the equity values adjust to provide an expected return consistent with these new risk
tolerances.
In our empirical tests of Hypothesis H2, we include control variables as proxies for these two
explanations for the inflation – equity fund flows relation.
11A related explanation is the so-called “policy anticipation effect” in which investors anticipate the central bank’saction of raising interest rates when inflation exceeds a target rate. Thus an increase in inflation would signal a tighteningof monetary policy, which is likely to have a negative effect on stock prices.
9
1.4 Mutual fund flows
Our main objective is to examine whether inflation and inflation illusion affects aggregate equity fund
flows. Hence, factors that may lead investors to choose to redirect their investments from one equity
fund to another (maybe in response to lower performance or higher fees etc.) are not relevant when
we examine aggregate flows into equity funds since reallocating money among equity funds will net
out at the aggregate level. However, for completeness, we summarize a few representative papers in
the mutual fund flow literature that examine factors affecting fund flows and caution that this is by
no means a comprehensive summary of this vast body of research.
In an important early paper in this area, Sirri and Tufano (1998) find that mutual fund investors
exhibit return chasing behavior and invest their funds disproportionately into funds that did well in
the prior period. Sirri and Tufano (1998) and Jain and Wu (2002) find evidence consistent with the
existence of search costs and show that when the fund is well known (e.g., via advertising the fund),
the impact of prior performance on fund flows is significant. Massa (2003) examines the impact of
load fees and fund family affiliation (number of different funds offered by the fund family) on the
stability of the fund flows. Nanda, Wang and Zheng (2004) examine the flow of funds into a fund
family and show that there is a positive spillover effect of “star performance” on the fund flows both
into the fund and into other funds in the same family.
Several authors have also examined the link between mutual fund flows and fund performance.
Zheng (1999) finds that funds that receive more inflows perform better subsequently. However,
Frazzini and Lamont (2008) examine flows within the mutual fund sector and test whether investor
sentiment is related to these flows. They find support for the “dumb money” explanation in which
retail investors move money to funds that invest in stocks in which there is high investor sentiment,
which perform poorly subsequently.
The extant studies, such as the ones discussed above, primarily focus on the causes and effects
of flows into individual funds or into funds aggregated at the family level. They do not focus on the
determinants of fund flows at the aggregate, economy-wide, level. In an early study, Warther (1995)
finds that mutual fund flows are correlated with concurrent stock returns and that an inflow of funds
into stock mutual funds results in positive stock returns. However, he does not examine the impact
of inflation on aggregate fund flows. We are aware of two recent studies that are closer in spirit to
our study. Kamstra, Kramer, Levin, and Wermers (2012) document a seasonal effect in mutual fund
10
flows. Specifically, they show that investors move their funds away from equities and into money
market and government bond funds in the Fall, and back to equities in the Spring. They suggest that
such investor behavior is the outcome of seasonality in investors’ risk preferences, being more averse
to financial risk in the fall/winter season and being more receptive to taking on risk in the summer.
More closely related to our paper, Chalmers, Kaul, and Phillips (2011) examine whether economic
variables such as the level of economic activity in the economy, the term and default spread, stock
and bond market volatility etc., affect the aggregate asset allocations of U.S. and Canadian mutual
fund investors. They conclude that when the economy is expected to perform well, investors direct
more of their investments towards equity funds. However, neither of these papers address the main
issues that are examined in our study: (a) whether inflation affects how mutual fund investors allocate
their wealth across different asset classes, and (b) the proposed mechanism - inflation illusion, Fama’s
(1981) proxy for growth, or risk - by which such an inflation effect might work.
2 Data and method
2.1 Data
We use the Federal Reserve Flow of Funds data to measure aggregate mutual fund flows at the
quarterly level from 1977 to 2013. The Flow of Funds tables that we rely on are F.120 - Money
Market Funds (mm), F.121 - Mutual Funds (mf), and F.122 Closed End (cef) and Exchange Traded
Funds (etf). We also gather data from F.204 - Checking Deposits (check) and F.205 - savings deposits
(save). All data is seasonally adjusted. From these data, we create four broad categories of flows –
Flows to Equity Funds, Bond Funds, Cash/Money Market Funds and Bank Deposits – as follows.
To create our flow measures, we combine specific line items from several flow of funds tables. For
example, flows into bond funds appear in Closed End Funds (cef), Exchange Traded Funds (etf),
Mutual Funds (mf) and Money Market Funds (mm). The definitions of each of our four fund flows
categories are as follows:
EquityF lows = equitiescef + equitiesetf + equitiesmf
11
BondF lows = treasuriescef +muniscef + corporatescef + treasuriesetf +munisetf
+ corporatesetf + treasuriesmf + agenciesmf +munismf + corporatesmf
+ syndicatedloanmf + treasuriesmm + agenciesmm +munismm
+ corporatesmm +miscmm
MoneyMarketF lows = fedfundsmf + commercialpapermf + checkingmm
+ timesavingsmm + fedfundsmm + openmarketmm
Deposits = checkingdepositschec + savingsdepositssave
We deflate the fund flow to each specific category by the nominal U.S. GDP. The resulting variable
that we use in our main empirical analyses is the quarterly flow to equity funds as a percentage of
GDP. We use flows into bond funds, money market funds and deposit accounts in our supplementary
analyses.12
Since the fund flows data is quarterly, we measure all other variables on a quarterly basis. To
control for potential return chasing behavior, we use the stock market return as a control variable,
measured as the quarterly return on the value-weighted market index, with distributions, from CRSP.
We obtain inflation data from the Fred database maintained by the St. Louis Federal Reserve Bank.
The appendix contains a list of all our explanatory variables, their definitions and data sources.
2.2 Measuring mispricing associated with inflation illusion
We measure the extent of mispricing induced by inflation illusion using the method of Campbell
and Vuolteenaho (2004), Campbell and Shiller (1988), and Campbell (1991). This approach has
been widely utilized in the literature to examine the effect of inflation illusion (e.g., Brunnermeier
and Julliard (2008), Chen, Lung, and Wang (2009)). Campbell and Vuolteenaho (2004) model
the mispricing caused by inflation illusion by considering objective versus subjective opinions about
returns and growth rates. Objective opinions are those that are free from bias, whereas the subjective
12As a robustness check, we also deflate fund flows by the aggregate total assets in that category (equity funds, bondfunds, money market funds, or bank deposits), in that quarter, and obtain qualitatively similar results.
12
opinions contain the potential for inflation illusion. From the Gordon growth model of stock valuation
and assuming constant dividend growth, we can express the dividend yield as:
Dt+1
Pt= R−G, (1)
where D is dividends, P is the price, R is the nominal cost of equity and G is the nominal expected
growth rate of dividends. Campbell and Vuolteenaho (2004) argue that there can be two sets of R and
G at any given time – an objective set (denoted with superscript O), and a subjective set (denoted
with superscript S). However, since there is only one observed dividend yield at any point in time,
the difference between the objective R and the objective G must equal the difference between the
subjective variables:
Dt+1
Pt= RO −GO = RS −GS . (2)
With a little algebraic manipulation, we can derive the following:
Dt+1
Pt= RS −GO + (GO −GS). (3)
The term in parentheses, the difference between the objective and subjective estimates of growth,
is the measure of mispricing due to inflation illusion. This mispricing occurs when investors do not
include inflation in their subjective estimate of G. Note that by construction, this mispricing could
equivalently be expressed as the difference between the objective and subjective costs of equity, R.
To estimate the mispricing component, Campbell and Vuolteenaho (2004) use the log-linear val-
uation model of Campbell and Shiller (1988). In the Campbell-Shiller model, the log dividend yield
is approximated (using a Taylor series expansion) as a function of the discounted future expected
returns and future dividend growth rates, where lower case variables indicate logged values:
dt−1 − pt−1 ≈k
ρ− 1+∞∑j=0
ρjEt−1ret+j −
∞∑j=0
ρjEt−1∆det+j . (4)
Returns and dividends (re and de) are defined as returns in excess of the log risk free rate. ∆de is
therefore the dividend growth in excess of the risk free rate. ρ and k are constants. In equation 4,
the second term on the right hand side is basically R and the third term on the right hand side is G.
13
These are either objective or subjective values, depending on how the expectations are taken.
We take equation 4 and apply the Campbell and Vuolteenaho (2004) VAR method to estimate
RO and the mispricing. Specifically we take a first-order VAR that includes the log return on the
S&P 500 index over the three-month Treasury bill (ret ), a risk premium measure (λt), measured as
the volatility of stock returns divided by the volatility of bond returns, the log dividend-price ratio
(dyt), and the exponentially smoothed moving average of inflation (πt). The VAR is re-estimated
every quarter, always using observations starting in the first quarter of 1962, to avoid any look-ahead
bias.
From the VAR, we first estimate the term∑∞
j=0 ρjEO
t−1ret+j under objective expectations. This
gives us ROt . The next step is to estimate mispricing by running a regression of RO
t on an intercept
and the risk-premium proxy λt. The mispricing is taken as the residual from the regression of∑∞j=0 ρ
jEOt−1r
et+j on an intercept and the risk-premium proxy λt:
ROt = α0 + α1λt + εt. (5)
The intuition for estimating the mispricing as the residual of this regression is as follows. If investors
do not suffer from inflation illusion, then a regression of excess stock returns on inflation should result
in no loading on the inflation variable. However, to the extent that investors do alter their estimates
of the excess expected return on stocks as a result of inflation, the objective R predicted by the VAR
will incorporate these errors. To extract these errors, equation 5 only relates returns to risk (and not
to inflation). Thus the residuals from this regression would be due to inflation induced mispricing.
We note that mispricing can be negative or positive, since it is clear from equation 5 that the
mispricing is defined as the residual. Both Chen, Lung, and Wang (2009) and Brunnermeier and
Julliard (2008) note that if investors have a reference level of inflation, then deviations from this
reference level will result in either a positive or negative pricing error.
2.3 Control variables for the proxy and risk hypotheses
The proxy or growth effect of inflation on stock prices can be seen by referencing our earlier equation
1:
Dt+1
Pt= R−G. (6)
14
If inflation has a negative effect on economic activity, then periods of higher inflation will result
in lower G and consequently a higher dividend yield (i.e., stocks are undervalued). We use two
variables to measure this “proxy” or growth effect. The first is the term premium since Fama and
French (1989) show that the term premium captures short-term business cycle conditions (low near
business cycle peaks, and high near troughs) and is related to returns on stock and long term bonds.
Estrella and Hardouvelis (1991) also show that high term premiums predict an increase in future real
economic activity. We compute the term premium as the difference between the yield on 30-year
bonds and 3-month T-bills. The second variable used is the forecast of real growth in corporate
profits four quarters ahead, and is obtained from the Survey of Professional Forecasters, available at
the Philadelphia Federal Reserve Bank website.
If inflation is correlated with greater market risk, then this would result in a higher R in equation
6, which will result in a higher dividend yield. The risk effect is measured with the default premium
and stock market volatility. We expect high default premiums and high stock market volatility to
be associated with higher levels of risk aversion on the part of investors. We estimate the default
premium as the difference between the yield on BAA bonds and AAA bonds (obtained from the
FRED database at the St. Louis Federal Reserve Bank), which captures the risk premium associated
with investing in risky securities. The stock market volatility is measured as the rolling 60-month
standard deviation of the monthly return (with distributions) on the CRSP value weighted market
index.
3 Results
3.1 Summary statistics
Table 1 presents summary statistics for the sample. We have 149 quarterly observations spanning the
years 1976:Q4 to 2013:Q4. The first four variables in Table 1 pertain to the net flows to the various
asset classes, deflated by the U.S. GDP. The average flow to equity funds is 0.5% per quarter. The
average flow to bond funds is 1.5% per quarter and that into money market funds averages 0.56% per
quarter. The amount of bank deposits increases every quarter on average by 3.8%. The term premium
and default premium are, on average, positive as one would expect. During our sample period, both
inflation and estimates of inflation illusion exhibit significant variation. Inflation averaged about
15
4% but ranged as high as nearly 15% in the early 1980s and near zero in the late 2000s. Average
mispricing is zero by construction (as discussed earlier), but there is significant variation with periods
of both positive and negative mispricing. Positive mispricing implies that the inflation illusion effect
is high and stocks are underpriced, while negative mispricing implies that inflation is below investor’s
reference rate and stocks may be overvalued.
In Table 2, we present correlations between the variables used in our study. There is a positive
correlation between flows into equity mutual funds and flows into bond funds and money market
funds, even though the estimates are not statistically significant. However, there is a strong negative
correlation between equity fund flows and flows into bank deposits. Of particular note is the significant
negative correlation between equity flows and inflation (-0.50), depicted visually in Figure 1. The
correlation of inflation with bond fund flows is also negative but the magnitude is smaller (-0.265),
whereas flows into money market funds are not associated with inflation. In sharp contrast, bank
deposits are significantly positively associated with inflation (0.21).
Turning to each of our hypotheses for the effect of inflation on equity fund flows, we find that the
two growth variables – term premium and expected growth in corporate profit – are not significantly
correlated with equity flows. Of the two risk explanatory variables, default premium is negatively
correlated with equity fund flows, a result consistent with its hypothesized effect. But, the correlation
with stock market volatility is significantly positive, opposite of the prediction of the risk hypoth-
esis. Finally, there is a significantly negative correlation (-0.36) between equity fund flows and the
mispricing variable, consistent with the inflation illusion hypothesis, depicted visually in Figure 2.
Both bond flows and money market flows are negatively correlated with the mispricing measure, but
deposit flows are significantly positively correlated (0.29) with the mispricing measure.
We also note that mispricing and inflation are not correlated in a significant manner. This result
indicates that the mispricing variable is not merely a noisy transformation of inflation. Figure 3
presents the time series of mispricing and inflation over our sample period. However, mispricing is
positively correlated with expected inflation (from the Survey of Professional Forecasters). Hence, we
conduct additional tests, both with and without controls for inflation, in order to more clearly isolate
the effect of inflation illusion on aggregate equity fund flows.
16
3.2 Inflation and equity prices
The underlying premise of our paper is that inflation depresses stock prices. To examine whether
this relation holds in our data set, we replicate a simple test that is presented in Campbell and
Vuolteenaho (2004) and examine the relation between inflation and the dividend to price ratio (or
dividend yield) for the S&P 500 Index. The basic model is as follows:
D
P t= α0 + α1λt + α2πt + εt, (7)
where DP t
is the dividend to price ratio, λt is a risk premium measure estimated as the volatility of
stocks divided by the volatility of bonds and πt is exponentially smoothed inflation. We estimate
equation 7 (using Newey-West corrected standard errors) and report the results in Table 3.
We find a strong positive relation between smoothed inflation, π and the dividend to price ratio,
indicating that during periods of higher inflation, the dividend yield on stocks is higher, indicative
of lower stock prices. This finding is similar to that reported by Campbell and Vuolteenaho (2004),
who also find a positive relation between inflation and the dividend yield. We note that the R2 of
56.2% is also in line with that reported in the earlier study.
3.3 Inflation and fund flows
Given the positive relation between inflation and the dividend yield, indicating that stocks prices
are relatively lower during inflationary periods, we now turn our attention to investigating whether
investors respond via their asset allocation decisions. We report the results of multivariate analyses
that test hypothesis H1, which postulates a negative relation between inflation and inflows into equity
mutual funds. As discussed above (Table 2), there is a strong negative correlation between inflation
and equity fund flows at the univariate level.
Table 4 presents the results of baseline regressions where the dependent variable is the quarterly
inflow into equity mutual funds and main explanatory variable of interest is the level of inflation.13
We include the lagged quarterly market return as a control variable to account for the possibility of
investors’ return chasing behavior. In model 1, we find some evidence of return chasing behavior,
since the coefficient on lagged market return is significantly positive (t=2.4). Importantly, we find
13In these and all subsequent regressions, we use the Newey-West corrections to control for autocorrelation.
17
that the level of inflation is significantly negatively related to subsequent equity fund flows (t = -
7.7). This result is consistent with our hypothesis H1 that during periods of high inflation, investors
will move their assets away from equities. The results are also economically significant. Our point
estimates suggest that a one standard deviation increase in inflation will result in a decline of 0.45%
in quarterly equity fund flows, which represents about $27 billion per quarter. In model 2, we use
contemporaneous explanatory variables instead of lagged values and find substantially similar results.
Again, we find that equity flows are significantly negatively related to the level of inflation. We
present these results graphically in Figure 1, which shows equity flows plotted against inflation.
3.4 The impact of inflation illusion on the equity fund flow relation
We now turn our attention to testing hypothesis H2, which states that the link between inflation and
equity fund flows is the outcome of inflation illusion on the part of investors. The dependent variable
in these models is the equity fund flow. The main explanatory variable of interest is mispricing,
which is our measure of inflation illusion (as defined earlier). Also included in the regressions are
controls for market returns and the proxy and risk explanations. We also present the results of several
alternative specifications that we used to test the robustness of our results. All our regressions present
Newey-West corrected t-statistics.
In model 1 in Table 5, we include the lagged term spread (to control for the proxy explanation),
the lagged default premium (to control for the risk explanation), and lagged market returns as control
variables. We find that the coefficient on mispricing is negative and significant (t=-3.0), consistent
with the inflation illusion explanation (hypothesis H2). In other words, as mispricing induced by
inflation illusion increases, the net flow of funds into equity funds decreases. We find that the term
spread is positively related to equity flows (as predicted by the proxy hypothesis). The coefficient on
default premium is negative and significant (t=-3.2), suggesting that investors move their assets away
from equities during periods when the investors are more concerned about risk, i.e., default premium
is high.
Models 2-4 are similar, except that we replace our proxy and risk explanatory variables one at a
time and examine the effects of alternative measures of these important control variables. In Model
2, we use the stock market volatility instead of default premium to measure risk. We find that the
coefficient on market volatility is negative and significant, consistent with the predictions of the risk
18
explanation. We continue to find that the coefficient on the inflation illusion variable is negative and
significant (t = -3.05) and that on the term spread is positive and significant. Models 3 and 4 replicate
models 1 and 2, except that we use the forecasted corporate profit growth instead of the term spread
to capture the proxy effect. Our main result continues to hold. In both specifications, the coefficient
on the inflation illusion variable is negative and significant (t = -3.09 and t = -3.08, respectively).
We continue to find mixed results for the risk explanation, with the coefficient on default premium
being negative as predicted, but that on market volatility being significantly positive, the opposite of
our expectation under the risk hypothesis. The coefficient on forecasted profit growth is positive and
significant in both models, consistent with the proxy hypothesis.
To summarize, in all four models, we find a statistically significant negative relation between
mispricing induced by inflation illusion and equity flows, suggesting that when investors are subject
to inflation illusion, they move their assets away from equities. This result provides strong support
for our hypothesis H2. Our results are also supportive of the proxy explanation, but the results are
mixed for the risk explanation.
3.5 Additional results
It is possible that aggregate equity flows shows some persistence. For example, Gallaher, Kaniel,
and Starks (2006) find evidence of persistence of flows into individual mutual funds. The persistence
may be the outcome of investors regularly investing in mutual funds via their retirement accounts.
Alternatively, if retail investors rely on media advertising or broker recommendations in making their
investment decisions and these effects persist for a period of time (e.g., a mutual fund advertising
campaign can cover several quarters where they market funds that have performed well in the recent
past, see Jain and Wu (2002)), we could observe persistence in fund flows. In any case, if there is
persistence in flows at the individual fund level, there may be persistence in flows at the aggregate
level also. Therefore, we replicate the analysis in models 1-4 in Table 5 but include lagged equity
flows as an additional control variable. The results are tabulated in Table 6.14 We find that the
coefficient on the mispricing measure remains negative and statistically significant in all models.
In Table 2, we reported a small (and statistically insignificant) positive correlation between in-
flation and mispricing. Therefore, it is unlikely that mispricing may simply be capturing the effect
14For brevity, in Table 6, we only tabulate the results from model 1 in Table 5. Detailed results for the other models2-4 are available from the authors upon request.
19
of inflation on equity fund flows. In any case, we repeat the analysis in Table 5 and add lagged
inflation as an additional control variable. We first include lagged inflation as an additional control
variable. Our results continue to hold. The results of replicating model 1 in Table 5 are reported
as model 2 in Table 6. We find that the negative effect of mispricing on equity fund flows persists,
even after controlling for lagged inflation. Furthermore, the coefficient on lagged inflation is negative
and statistically significant, suggestive of the positive effect of inflation on the dividend yield that
we reported in Table 3. We find (results not separately tabulated) similar results when we replicate
models 2-4 in Table 5, the coefficient on the mispricing remains negative and statistically significant
at the one-percent level. Second, we replace lagged realized inflation with forecasted inflation, using
the forecasts of the change in the GDP deflator (data from the Survey of Professional Forecasters,
available at the Federal Reserve Bank of Philadelphia). The results of replicating model 1 in Table 5
are reported as model 3 in Table 6.The coefficient on this measure of expected inflation is consistently
negative. Importantly, the coefficient on the mispricing variable remains negative and significant. We
find a similar result (not separately tabulated) when we replicate models 2-4 in Table 5.
Overall, our results offer consistent support for hypothesis H2, which argues that the mispricing
associated with inflation illusion (of the Modigliani and Cohn (1979) type) induces investors to move
away from equities during times when the mispricing effect is large. Our results are less supportive
of the proxy or the risk explanations.
3.6 The effect of inflation illusion on flows to other asset classes
Our results are supportive of the hypothesis that inflation induced valuation errors leads to a net
decrease in flows to equity funds. We now examine whether a similar negative relation also exists
between inflation illusion measures and flows into three other asset classes – bonds, money market
securities, and bank deposits. While theory predicts a negative impact of inflation illusion on equities,
the effect of inflation illusion on these fixed income assets classes is unclear.
First, there it could be argued that there should be no relation between fixed income flows and
inflation illusion because these assets have fixed nominal cash flows and are therefore not subject to
valuation errors based on differences in objective and subjective growth rates. However, if investors
are diverting funds away from equities during inflationary periods, then some other asset class must
be receiving these flows. If so, we could observe a positive link between measures of inflation illusion
20
and flows into non-equity asset classes. A third possibility also exists. If the fixed income asset class
is comprised heavily of corporate bonds, the value depressing effect of inflation illusion on firm value
may negatively impact the debt securities of those companies.15 This effect would result in a negative
relation between inflation illusion and flows to bond funds, but should not have an impact on flows
to other asset classes such as bank deposits. Clearly, the effect of inflation illusion on flows to debt
funds is an empirical question.
As documented earlier in Table 2, equity flows are not significantly correlated with flows into bonds
or money market assets, but are significantly negatively correlated with flows into bank deposits. This
suggests that investors park their assets in bank deposits during inflationary periods. In Table 7, we
replicate the analysis in Table 5 for the three asset classes separately - flows into bond funds, money
market funds, and bank deposits - and test our assertion more formally.16
The results indicate that investors move their assets away from bond funds when the level of
inflation illusion is high, similar to equities. In model 1 in Table 7, the coefficient on mispricing is
negative and weakly significant (t = -1.845). However, the significance levels are higher when we
replicate models 2-4 in Table 5, and all three coefficients are negative and statistically significant
at the ten-percent level or better. When we include lagged bond flows, then the coefficient on
mispricing becomes statistically insignificant in all four models (not separately tabulated). There
is little support for the proxy and the risk explanations since the coefficients on those variables are
generally not statistically significant.
The results in model 2 in Table 7 suggest that inflation illusion has a negligible effect on inflows
into money market funds. The coefficient on mispricing is negative, but is not statistically significant.
When we replicate models 2-4 in Table 5, the coefficient on mispricing is negative and significant in
two out of three models. When we include lagged bond flows, the coefficient on mispricing becomes
statistically insignificant in all four models (not separately tabulated). The risk explanation again
finds little empirical support since none of the coefficients are significant at the usual levels. However,
the proxy explanation now finds support, with investors moving their assets away from money market
funds when they expect future economic activity to be high.17
15This could occur, if, as a result of inflation illusion, investors believe that the firm will earn lower cash flows,negatively affecting bond values.
16Again, in Table 7, we only tabulate the specification from model 1 in Table 5 for brevity. Detailed results ofreplicating models 2-4 are not tabulated but are available upon request.
17This may be a mechanical association if it is corporations (rather than individual investors) who use their cash onhand (invested in money market accounts) to fund their investments in real assets, in anticipation of future growth.
21
Finally, we examine the flows to bank deposits, including checking accounts and CDs. The results
in model 3 in Table 7 indicate that inflation illusion has a significantly positive effect on inflows into
bank deposits. When we replicate models 2-4 in Table 5, the coefficient on mispricing is positive and
significant in all three models. When we include lagged flows into bank deposits, the coefficient on
mispricing remains statistically significant in all four models (not separately tabulated). This result
offers further support for the inflation illusion hypothesis. When inflation illusion is high, investors
reallocate their assets away from equities and invest in secure deposits with a guaranteed nominal
return. Bank accounts have the additional benefit that they are FDIC insured and are very liquid.
Further, retail investors, who are more likely to be subject to inflation illusion, are more likely to be
aware of bank deposits as a safe and liquid alternative asset class.
As an additional robustness check, we repeat the tests in Table 7 and control for lagged inflation or
expected inflation, as before. The results (not tabulated separately to conserve space) are qualitatively
the same as those reported above.
3.7 Impact on equity prices
The results presented above show that investors are subject to inflation illusion and move their assets
away from equities and primarily into bank deposits during inflationary periods. Relatedly, Campbell
and Vuolteenaho (2004) find that inflation illusion has a real and significant effect on dividend yields.
In particular, they find that dividend yield is positively related to the level of mispricing, indicating
that high inflation illusion is associated with depressed equity prices. We conjecture that the outflows
from equity funds due to inflation illusion could have a measurable, downward price pressure on
stock prices. In this scenario, the decrease in stock prices when inflation illusion is high would be
concentrated in periods when investors react to high inflation illusion by moving their assets away
from equities.
To test if a similar result exists in our data, we divide our sample based on whether the equity flows
are above or below median equity flows and whether the mispricing measure is positive or negative.
For each of the resulting four groups, we measure the dividend to price ratio for the aggregate stock
market and compare them across the groups.
We present the results of this analysis in Table 8. Of particular interest are the top right and
bottom left cells, which represent low levels of mispricing/high equity flows and high inflation illusion
22
and low equity flows. The average DP ratio for the low mispricing/high equity flows periods is 2.01%.
The average DP ratio for the high mispricing/low equity flows group is more than twice as large:
4.30%. The difference between these two values is highly significant (t = 13.41). In contrast, the
equity prices are not as depressed (mean DP ratio is 2.66%) when the mispricing is high but the equity
flows are also high and investors do not move their assets away from equities. At a broader level,
this result provides initial evidence that the investors’ asset allocation behavior documented here
(i.e., their tendency to move assets away from equities when they are subject to inflation illusion,
leading to downward pressure on equity prices) may have an important role to play in explaining
the link between inflation illusion and stock prices documented in Campbell and Vuolteenaho (2004).
However, we leave a detailed examination of this effect to future research.
4 Conclusion
In this paper we examine whether inflation affects flows into equity mutual funds at the economy-
wide level, and find that a high level of inflation consistently leads investors to reduce fund flows to
equities. One possible explanation for the link between inflation and equity fund flows is the inflation
illusion hypothesis, initially put forth by Modigliani and Cohn (1979). Under the inflation illusion
explanation, investors increase the discount rate used to value stocks when inflation increases, but
they fail to incorporate the effect of inflation into their estimates of nominal growth rate of cash flows.
The outcome is that investors will tend to undervalue stocks in the presence of inflation, leading them
to move their assets away from equities. Our tests reveal strong support for the inflation illusion
hypothesis.
In our analysis we control for two other explanations for the observed link between inflation and
equity fund flows - the proxy effect and the risk effect. The proxy effect states that inflation acts as
a proxy for poorer economic conditions, leading investors to rationally infer lower stock valuations.
The risk effect argues that investors will reduce their valuations of risky equity assets during periods
of high inflation either because inflation creates greater uncertainty in the macro economy or because
it increases investors’ risk aversion. Under both explanations, the lower stock valuation would lead
investors to move their assets away from equities and into other asset classes. Our tests offer little to
no support for these two explanations.
23
We also find that inflation illusion has explanatory power over the flows into deposit accounts.
We interpret this finding as being consistent with inflation illusion leading investors to reduce their
flows to equity and instead invest their money in deposits which are lower risk and have potentially
high nominal returns (due to inflation).
24
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Appendix: Variable Definitions
Variable Name Definition Data Source
Mispricing The inflation illusion induceddifference between the objectivedividend growth rate and thesubjective growth rate.
CRSP, St Louis Fed.
Term Premium Term Premium - difference betweenten year T bond yield andannualized 1 month T bill yield.
St Louis Fed.
Default Premium Default Premium - differencebetween the yield on baa corporateand an aaa corporate bond.
St Louis Fed.
E(Profit Growth) 4 Quarter ahead corporate profitgrowth forecast.
Survey of Professional Forecasters.Philadelphia Fed.
Equity Risk Trailing 60 quarter stock marketvolatility.
CRSP.
Inflation Change in the consumer priceindex.
St Louis Fed.
E(Inflation) 4 Quarter ahead change in theGDP deflator forecast.
Survey of Professional Forecasters.Philadelphia Fed.
28
Table 1: Summary Statistics Variable definitions are provided in the appendix
Mean Std Dev Min Max
Aggregate fund flowsEquity Flows 0.0085 0.0088 -0.0136 0.0363Bond Flows 0.0154 0.0176 -0.0292 0.0966MM Flows 0.0056 0.0145 -0.0545 0.0417Deposit Flows 0.0378 0.0270 -0.0397 0.1432
Macroeconomic variablesMispricing 0.0000 0.2630 -0.7631 0.7189Term Premium 0.0121 0.0123 -0.0307 0.0333Default Premium 0.0111 0.0047 0.0055 0.0338Equity Risk 0.1574 0.0291 0.0909 0.2007Inflation 0.0392 0.0287 -0.0143 0.1476Market Return 0.0309 0.0847 -0.2371 0.2130E(Profit Growth) 0.0398 0.0752 -0.1631 0.4754E(Inflation) 0.0347 0.0201 0.0118 0.0926
29
Tab
le2:
Corr
ela
tion
sV
ari
able
defi
nit
ion
sar
ep
rovid
edin
the
app
end
ix.
Sig
nifi
can
cele
vels
are
ind
icate
das
*p<
0.05
**
p<
0.01
***
p<
0.0
01
Equ
ity
Bon
dM
MD
epos
itT
erm
Def
ault
Equit
yM
ark
etE
(Pro
fit
Flo
ws
Flo
ws
Flo
ws
Flo
ws
Mis
pri
cin
gP
rem
ium
Pre
miu
mR
isk
Infl
ati
on
Ret
urn
Gro
wth
)
Bon
dF
low
s0.
090
MM
Flo
ws
0.1
48
-0.0
46D
eposi
tF
low
s-0
.212*
*0.0
13
-0.1
09M
isp
rici
ng
-0.3
57*
**-0
.205
*-0
.136
0.28
7***
Ter
mP
rem
ium
0.1
63*
0.123
-0.3
86**
*-0
.090
0.08
34D
efau
ltP
rem
ium
-0.4
63*
**0.
076
-0.1
480.
283*
**0.
301*
**0.
0118
Equ
ity
Ris
k-0
.394*
**-0
.156
-0.2
85**
*0.
143
0.28
1***
0.25
6**
0.17
4*In
flati
on-0
.503*
**-0
.265
**0.
116
0.20
6*0.
067
-0.6
01**
*0.
229*
*0.0
92
Mar
ket
Ret
urn
0.1
84*
-0.0
900.0
120.
045
0.01
20.
039
-0.0
84-0
.027
-0.0
31
E(P
rofi
tG
row
th)
0.0
87
-0.0
11-0
.264
**0.
017
0.08
20.
451*
**0.
154
0.139
-0.3
03***
0.0
60
E(I
nfl
atio
n)
-0.6
00**
*-0
.346*
**0.
087
0.25
3**
0.28
1***
-0.5
54**
*0.
339*
**0.1
13
0.8
92***
0.0
29
-0.1
89*
30
Table 3: Regression of the Dividend Yield on the Risk Premium and Inflation Variable def-initions are provided in the appendix. T-statistics are in parenthesis, significance levels are indicatedas * p< 0.1; ** p< 0.05; *** p< 0.01
dp
Intercept 0.0157***(8.861)
λ 0.0243***(-5.051)
Smoothed Inflation 1.467***(9.025)
R2 0.562Observations 149
31
Table 4: Regressions of Equity Fund Flows on Inflation Variable definitions are provided inthe appendix. T-statistics are in parenthesis, significance levels are indicated as * p< 0.1; ** p< 0.05;*** p< 0.01.
(1) (2)Equity Flows Equity Flows
Intercept 0.014*** 0.014***(11.440) (10.690)
Inflationt−1 -0.158***(-8.010)
Market Returnt−1 0.020**(2.238)
Inflation -0.153***(-7.681)
Market Return 0.018**(2.572)
R2 0.307 0.281Observations 148 149
32
Table 5: Regressions of Equity Fund Flows on Inflation Illusion Variable definitions areprovided in the appendix. T-statistics are in parenthesis, significance levels are indicated as * p< 0.1;** p< 0.05; *** p< 0.01.
(1) (2) (3) (4)Equity Flows Equity Flows Equity Flows Equity Flows
Intercept 0.014*** 0.021*** 0.015*** 0.021***(5.411) (5.278) (6.393) (5.170)
Market Returnt−1 0.018** 0.020** 0.017** 0.019**(2.548) (2.345) (2.402) (2.448)
Mispricingt−1 -0.009*** -0.010*** -0.009*** -0.010***(-3.050) (-3.046) (-3.090) (-3.078)
Term Premiumt−1 0.128** 0.184***(2.210) (3.400)
Default Premiumt−1 -0.647*** -0.710***(-3.210) (-3.236)
Equity Riskt−1 -0.097*** -0.086***(-3.826) (-3.318)
E(Profit Growth)t−1 0.026*** 0.024***(3.854) (3.109)
R2 0.320 0.301 0.338 0.282Observations 148 148 148 148
33
Table 6: Regressions of Equity Fund Flows - Alternative Specifications Variable definitionsare provided in the appendix. T-statistics are in parenthesis, significance levels are indicated as *p< 0.1; ** p< 0.05; *** p< 0.01.
(1) (2) (3)Equity Flows Equity Flows Equity Flows
Intercept 0.006*** 0.021*** 0.022***(2.837) (10.860) (12.380)
Market Returnt−1 0.010 0.019*** 0.023***(1.548) (3.132) (3.684)
Mispricingt−1 -0.005** -0.008*** -0.004**(-2.237) (-4.930) (-2.423)
Term Premiumt−1 0.062 -0.106* -0.123**(1.611) (-1.676) (-2.127)
Default Premiumt−1 -0.283* -0.426*** -0.336**(-1.691) (-3.015) (-2.300)
Equity Flowst−1 0.535***(6.057)
Inflationt−1 -0.164***(-6.486)
E(Inflation)t−1 -0.264***(-6.944)
R2 0.511 0.486 0.507Observations 148 148 148
34
Table 7: Regressions of Bond Fund, Money Market and Deposit Flows on Inflation IllusionVariable definitions are provided in the appendix. T-statistics are in parenthesis, significance levelsare indicated as * p< 0.1; ** p< 0.05; *** p< 0.01.
(1) (2) (3)Bond Flows MM Flows Deposit Flows
Intercept 0.0194*** 0.0153*** 0.0307***(4.713) (4.664) (3.760)
Market Returnt−1 -0.0412*** 0.00519 -0.0162(-2.636) (0.390) (-0.540)
Mispricingt−1 -0.0102* -0.00566* 0.0263***(-1.845) (-1.684) (2.794)
Term Premiumt−1 0.0328 -0.558*** -0.233(0.286) (-5.610) (-1.395)
Default Premiumt−1 -0.276 -0.288 0.915(-0.949) (-1.069) (1.200)
R2 0.072 0.253 0.129Observations 148 148 148
35
Table 8: Inflation illusion, equity fund flows and dividend yields Variable definitions areprovided in the appendix. T-statistics are in parenthesis, significance levels are indicated as * p< 0.1;** p< 0.05; *** p< 0.01.
Equity Fund Flows
Low High Row difference
Low 3.662% 2.010% 1.652%***Mispricing n=18 n=62 (8.133)
High 4.301% 2.263% 2.038%***n=41 n=27 (8.756)
column diff -0.639%** -0.253%*(-2.058) (-1.746)
Diagonal diff 2-3 -2.291%***(-13.409)
1-4 1.399%***(5.474)
36
−2
02
4E
quity
Flo
ws
(%)
−5 0 5 10 15Inflation (%)
Figure 1: Equity Flows and Inflation The figure shows the change in the CPI and the net equity flows. The linerepresents the best fit line, and the shaded area is the 95% confidence interval.
37
−2
02
4E
quity
Flo
ws
(%)
−1 −.5 0 .5 1Mispricing
Figure 2: Equity Fund Flows and Inflation Illusion The figure shows equity fund flows and mispricing due toinflation illusion.The line represents the best fit line, and the shaded area is the 95% confidence interval.
38
−5
05
1015
Infla
tion
(%)
−1
−.5
0.5
1M
ispr
icin
g
1975q1 1980q1 1985q1 1990q1 1995q1 2000q1 2005q1 2010q1
Mispricing Inflation
Figure 3: Inflation and Mispricing The figure shows the change in the CPI and mispricing due to inflation illusion.
39
