Hostname: page-component-78c5997874-j824f Total loading time: 0 Render date: 2024-11-15T12:40:13.184Z Has data issue: false hasContentIssue false
  • English
  • Français

Tail Risk and the Cross-Section of Mutual Fund Expected Returns

Published online by Cambridge University Press:  24 August 2018

Nikolaos Karagiannis  and
Konstantinos Tolikas
Get access Rights & Permissions [Opens in a new window]

Abstract

We test for the presence of a tail risk premium in the cross-section of mutual fund returns and find that the top tail risk quintile of funds outperforms the bottom by 4.4% per annum. This premium is not simply a reward for market risk, nor do commonly used risk factors offer an adequate explanation. Our findings hold across double-sorted portfolios formed on tail risk and a number of fund characteristics. We also find that funds susceptible to tail risk tend to be small, young, have high management fees, and have managers who do not risk their own capital.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 54 , Issue 1 , February 2019 , pp. 425 - 447
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2018 

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

Footnotes

1

We are grateful to an anonymous referee and Jennifer Conrad (the editor), whose thoughtful and constructive comments helped to substantially improve our article. We also thank Hans Degryse, Chris Florackis, and Alexandros Kostakis for helpful comments.

References

Adam, T. R., and Klipper, L.. “Fire-Sale Cascades: Empirical Evidence from the Mutual Fund Industry.” European Finance Association Meetings Paper (2017).Google Scholar
Agarwal, V.; Ruenzi, S.; and Weigert, F.. “Tail Risk in Hedge Funds: A Unique View from Portfolio Holdings.” Journal of Financial Economics, 125 (2017), 610–636.Google Scholar
Ang, A.; Chen, J.; and Xing, Y.. “Downside Risk.” Review of Financial Studies, 19 (2006), 1191–1239.Google Scholar
Badrinath, S. G., and Wahal, S.. “Momentum Trading by Institutions.” Journal of Finance, 57 (2002), 2449–2478.Google Scholar
Bali, T.; Demirtas, K. O.; and Levy, H.. “Is There an Intertemporal Relation between Downside Risk and Expected Returns.” Journal of Financial and Quantitative Analysis, 44 (2009), 883–909.Google Scholar
Barro, R. J.“Rare Disasters and Asset Markets in the Twentieth Century.” Quarterly Journal of Economics, 121 (2006), 823–866.Google Scholar
Barroso, P., and Santa-Clara, P.. “Momentum Has Its Moments.” Journal of Financial Economics, 116 (2015), 111–120.Google Scholar
Berk, J. B., and van Binsbergen, J. H.. “Measuring Skill in the Mutual Fund Industry.” Journal of Financial Economics, 118 (2015), 1–20.Google Scholar
Berkman, H.; Jacobsen, B.; and Lee, J. B.. “Time-Varying Rare Disaster Risk and Stock Returns.” Journal of Financial Economics, 101 (2011), 313–332.Google Scholar
Bloom, N.“The Impact of Uncertainty Shocks.” Econometrica, 77 (2009), 623–665.Google Scholar
Bollerslev, T., and Todorov, V.. “Tails, Fears, and Risk Premia.” Journal of Finance, 66 (2011), 2165–2211.Google Scholar
Brown, K. C.; Harlow, W. V.; and Starks, L. T.. “Of Tournaments and Temptations: An Analysis of Managerial Incentives in the Mutual Fund Industry.” Journal of Finance, 51 (1996), 85–110.Google Scholar
Brown, N. C.; Wei, K. D.; and Wermers, R.. “Analyst Recommendations, Mutual Fund Herding, and Overreaction in Stock Prices.” Management Science, 60 (2014), 1–20.Google Scholar
Carhart, M.“On Persistence in Mutual Fund Performance.” Journal of Finance, 52 (1997), 57–82.Google Scholar
Chang, B. Y.; Christoffersen, P.; and Jacobs, K.. “Market Skewness Risk and the Cross Section of Stock Returns.” Journal of Financial Economics, 107 (2013), 46–68.Google Scholar
Chen, J.; Hong, H.; Huang, M.; and Kubik, J. D.. “Does Fund Size Erode Mutual Fund Performance? The Role of Liquidity and Organization.” American Economic Review, 94 (2004), 1276–1302.Google Scholar
Chevalier, J., and Ellison, G.. “Risk Taking by Mutual Funds as a Response to Incentives.” Journal of Political Economy, 105 (1997), 1167–1200.Google Scholar
Coval, J., and Stafford, E.. “Asset Fire Sales (and Purchases) in Equity Markets.” Journal of Financial Economics, 86 (2007), 479–512.Google Scholar
Daniel, K.; Jagannathan, R.; and Kim, S.. “Tail Risk in Momentum Strategy Returns.” National Bureau of Economic Research Working Paper No. 18169 (2017).Google Scholar
Daniel, K., and Moskowitz, T. J.. “Momentum Crashes.” Journal of Financial Economics, 122 (2016), 221–247.Google Scholar
Dass, N.; Massa, M.; and Patgiri, R.. “Mutual Funds and Bubbles: The Surprising Role of Contractual Incentives.” Review of Financial Studies, 21 (2008), 51–99.Google Scholar
De Long, J. B.; Shleifer, A.; Summers, L. H.; and Waldmann, R. J.. “Positive Feedback Investment Strategies and Destabilizing Rational Speculation.” Journal of Finance, 45 (1990), 379–395.Google Scholar
Del Guercio, D., and Reuter, J.. “Mutual Fund Performance and the Incentive to Generate Alpha.” Journal of Finance, 69 (2014), 1673–1704.Google Scholar
Edelen, R.“Investor Flows and the Assessed Performance of Open-End Fund Managers.” Journal of Financial Economics, 53 (1999), 439–466.Google Scholar
Fama, E. F., and French, K. R.. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics, 33 (1993), 3–56.Google Scholar
Fama, E. F., and French, K. R.. “Luck versus Skill in the Cross-Section of Mutual Fund Returns.” Journal of Finance, 65 (2010), 1915–1947.Google Scholar
Fama, E. F., and MacBeth, J. D.. “Risk, Return, and Equilibrium: Empirical Tests.” Journal of Political Economy, 81 (1973), 607–636.Google Scholar
Farago, A., and Tédongap, R.. “Downside Risks and the Cross-Section of Asset Returns.” Journal of Financial Economics, 129 (2018), 69–86.Google Scholar
Gabaix, X.“Power Laws in Economics and Finance.” Annual Review of Economics, 1 (2009), 255–293.Google Scholar
Gabaix, X.“Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance.” Quarterly Journal of Economics, 127 (2012), 645–700.Google Scholar
Gabaix, X.; Gopikrishnan, P.; Plerou, V.; and Stanley, H.. “Institutional Investors and Stock Market Volatility.” Quarterly Journal of Economics, 121 (2006), 461–504.Google Scholar
Gourio, F.“Disaster Risk and Business Cycles.” American Economic Review, 102 (2012), 2734–2766.Google Scholar
Grinblatt, M., and Titman, S.. “Mutual Fund Performance: An Analysis of Quarterly Portfolio Holdings.” Journal of Business, 62 (1989), 393–416.Google Scholar
Grinblatt, M., and Titman, S.. “The Persistence of Mutual Fund Performance.” Journal of Finance, 47 (1992), 1977–1984.Google Scholar
Grinblatt, M.; Titman, S.; and Wermers, R.. “Momentum Investment Strategies, Portfolio Performance and Herding: A Study of Mutual Fund Behavior.” American Economic Review, 85 (1995), 1088–1111.Google Scholar
Gruber, M. J.“Another Puzzle: The Growth of Actively Managed Mutual Funds.” Journal of Finance, 51 (1996), 783–810.Google Scholar
Hill, B.“A Simple General Approach to Inference about the Tail of a Distribution.” Annals of Statistics, 3 (1975), 1163–1174.Google Scholar
Huang, J.; Sialm, C.; and Zhang, H.. “Risk Shifting and Mutual Fund Performance.” Review of Financial Studies, 24 (2011), 2575–2616.Google Scholar
Investment Company Institute. Investment Company Factbook: A Review of Trends and Activities in the U.S. Investment Company Industry, 55th ed. Washington, DC: Investment Company Institute (2016).Google Scholar
Jensen, M., and Meckling, W.. “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure.” Journal of Financial Economics, 3 (1976), 305–360.Google Scholar
Kelly, B.“The Dynamic Power Law Model.” Extremes, 17 (2014), 557–583.Google Scholar
Kelly, B., and Jiang, H.. “Tail Risk and Asset Prices.” Review of Financial Studies, 27 (2014), 2841–2871.Google Scholar
Kempf, A.; Ruenzi, S.; and Thiele, T.. “Employment Risk, Compensation Incentives, and Managerial Risk Taking: Evidence from the Mutual Fund Industry.” Journal of Financial Economics, 92 (2009), 92–108.Google Scholar
Khorana, A.; Servaes, H.; and Wedge, L.. “Portfolio Manager Ownership and Fund Performance.” Journal of Financial Economics, 85 (2007), 179–204.Google Scholar
Koski, J. L., and Pontiff, J.. “How Are Derivatives Used? Evidence from the Mutual Fund Industry.” Journal of Finance, 54 (1999), 791–816.Google Scholar
Lakonishok, J.; Shleifer, A.; and Vishny, R. W.. “The Impact of Institutional Trading on Stock Prices.” Journal of Financial Economics, 32 (1992), 23–43.Google Scholar
Lettau, M.; Maggiori, M.; and Weber, M.. “Conditional Risk Premia in Currency Markets and Other Asset Classes.” Journal of Financial Economics, 114 (2014), 197–225.Google Scholar
Ma, L., and Tang, Y.. “Portfolio Manager Ownership and Mutual Fund Risk Taking.” Management Science, forthcoming (2018).Google Scholar
Morningstar Direct. “Glossary.” Available at http://www.morningstar.co.uk/uk/glossary/E.aspx(2017).Google Scholar
Newey, W., and West, K.. “A Simple, Positive Semi-Definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix.” Econometrica, 55 (1987), 703–708.Google Scholar
Newey, W., and West, K.. “Automatic Lag Selection in Covariance Matrix Estimation.” Review of Economic Studies, 61 (1994), 631–653.Google Scholar
Nofsinger, J., and Sias, R.. “Herding and Feedback Trading by Institutional and Individual Investors.” Journal of Finance, 54 (1999), 2263–2295.Google Scholar
Pastor, L., and Stambaugh, R. F.. “Liquidity Risk and Expected Stock Returns.” Journal of Political Economy, 111 (2003), 642–685.Google Scholar
Pastor, L., and Stambaugh, R. F.. “On the Size of the Active Management Industry.” Journal of Political Economy, 120 (2012), 740–781.Google Scholar
Rakowski, D.“Fund Flow Volatility and Performance.” Journal of Financial and Quantitative Analysis, 45 (2010), 223–237.Google Scholar
Roll, R.“A Mean/Variance Analysis of Tracking Error.” Journal of Portfolio Management, 18 (1992), 13–22.Google Scholar
Roy, A. D.“Safety First and the Holding of Assets.” Econometrica, 20 (1952), 431–449.Google Scholar
Sias, R. W.“Institutional Herding.” Review of Financial Studies, 17 (2004), 165–206.Google Scholar
Tsai, J., and Wachter, J. A.. “Rare Booms and Disasters in a Multisector Endowment Economy.” Review of Financial Studies, 29 (2016), 1113–1169.Google Scholar
Wachter, J. A.“Can Time-Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility?” Journal of Finance, 68 (2013), 987–1035.Google Scholar
Weigert, F.“Crash Aversion and the Cross-Section of Expected Stock Returns Worldwide.” Review of Asset Pricing Studies, 6 (2016), 135–178.Google Scholar
Welch, I.“The Time-Varying Importance of Disaster Risk.” Financial Analysts Journal, 72 (2016), 14–30.Google Scholar
Wermers, R.“Mutual Fund Herding and the Impact on Stock Prices.” Journal of Finance, 54 (1999), 581–622.Google Scholar
Wermers, R.“Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses.” Journal of Finance, 55 (2000), 1655–1695.Google Scholar