The Effect of the Business Cycle on Demand for Exchange-Traded Funds and Mutual Funds

Abstract

This study examines the investor behavior surrounding equity and fixed income exchange-traded funds (ETFs), beginning by studying the effects of several factors on investor demand for ETFs. In particular, I analyze the effect of a novel factor, the business cycle, on equity and fixed income ETF demand over 1999-2018. To my knowledge, this is the broadest time period any paper has analyzed previously. I find that investors generally time the market, buying ETFs when they believe that the returns of the underlying assets the fund holds will increase. Thus, demand for fixed income ETFs tends to increase during poor economic conditions. However, I also find some evidence of contrarian investor behavior or hedging by institutional investors as demand for equity ETFs increases rather than decreases as expected during economic downturns. The second part of this study examines the substitutability and complementarity of mutual funds and ETFs, and the effect the business cycle has on this relationship. I believe that during economic downturns, investors view equity ETFs and mutual funds as substitutes, with a price or return effect dominating across the business cycle. For every 1% increase in returns to the average equity mutual fund, there is a 0.895% to 3.373% decrease in net flow of funds to the average equity ETF. On the other hand, I find that fixed income ETFs and mutual funds are complements across the business cycle due to a difference in clientele, with long-term, cost-sensitive investors preferring ETFs. For every 1% increase in fund flow (1% increase in returns) to the average fixed income mutual fund, there is a 0.0098% to 0.0349% (2.495% to 4.792%) increase in fund flow to the average fixed income ETF.