Cautious Risk Takers: Investor Preferences and Demand for Active Management (Digest summary)

Despite the relatively poor performance of active mutual funds compared with passive funds, the amount of assets under active management still far exceeds that of index funds. This has attracted significant interest in the mutual fund discourse.

The authors create bootstrapped samples of monthly returns of actively and passively managed mutual funds to compare their return distributions. To isolate the active component of mutual fund returns, the market-neutral excess returns of active funds over passive benchmarks are constructed. The authors use the skewness of returns and of excess returns to measure the ability of active funds to capture upside. To measure downside protection of active portfolios, they use co-skewness with market returns, downmarket betas of excess returns, and excess returns’ loadings on aggregate jump and volatility risk factors constructed from straddle portfolios of S&P 500 Index options.

Two types of data are primarily used in the empirical analyses: S&P 500 index option prices and mutual fund flows and returns. The data on S&P 500 Index options are from OptionMetrics for February 1996–December 2008, which is the main sample period for fund flow analyses because fund flows rely on risk preference measures derived from option prices and returns. These options are European and can be hedged using the active market for S&P 500 Index futures. The authors select the monthly quotes of options closest to 28 days from each month’s expiration date and use bid and ask prices. The term structure of default-free interest rates is from OptionMetrics. Illiquid options are removed from the sample, and the authors infer the option-implied underlying price to avoid nonsynchronous recording between options prices and the underlying index. S&P 500 Index returns are also obtained to estimate the probability distribution function.

Although previous researchers have modeled state-dependent skill in an attempt to rationalize investments in actively managed funds, the authors explore factors involved in the demand for active management that derive from investors’ downside hedging or upside seeking. Relative to passive benchmarks, active value mutual funds achieve greater downside protection whereas active growth mutual funds deliver stronger upside potential. The authors also link variation in investor preferences to fund flows and demonstrate that investor preference proxies have significant explanatory power for flows into actively managed mutual funds. For example, fund flows into retirement value funds exhibit increased sensitivity to downside protection preference compared with retail funds. However, fund flows into retail growth funds demonstrate more sensitivity to upside potential than their retirement counterparts. This finding suggests that investors tend to use a retail fund portfolio for more aggressive investments.

The authors’ findings are important in establishing the substantial effect of distributional features of fund performance—more than that of mean performance—on the demand for active funds. The research has important implications for the discussion of managerial skill and fund flows because it shows a new dimension of skill related to the fund return distribution’s tail properties.