Does MAX matter for mutual funds?

Abstract

Extreme returns (MAX) have been shown to impact future expected stock returns. We examine whether this relationship is present in mutual fund returns. We find that high MAX funds, as measured by past extreme daily returns, underperform both in portfolio sorts and cross‐sectional tests. We further test possible explanations for why MAX funds underperform. First, we measure mutual fund flows to determine investor response to MAX. Second, we examine the underlying holdings of MAX funds to measure their concentration in MAX stocks. We find evidence that both fund flows and holdings contribute to the MAX effect on mutual fund returns.

Why Do Mutual Funds Hold Lottery Stocks?

“…A plausible explanation is that investors' preference for a small chance of a large payoff is strong enough to lead to overvaluation of these assets. Goldie, Henry and Kassa (2019) and Akbas and Genc (2020) show that lottery preferences also extend to mutual fund investors as their investment flows respond strongly to extreme positive fund returns. We contribute to this literature by assessing whether fund managers select lottery stocks i) to cater to fund investors' preferences for lottery-like returns, ii) to satisfy their own preferences for such returns, or iii) due to strategic risk-shifting considerations.…”

Market States and Lottery Preference: Evidence from Chinese Open‐End Funds*

“…First, while existing studies find a positive relationship between fund lottery feature and future flows (Goldie et al . 2019; Akbas and Genc 2020), we show that the relationship is state‐dependent: when the state of the market is unfavorable, high maximum returns indeed attract higher future flows; when the state of the market is good, however, the positive relationship becomes weak or reversed. We also show that such preferences of fund investors are irrational because high maximum returns during market downturns (upturns) tend to be associated with worse (better) performance.…”