Cautious Risk-Takers: Investor Preferences and Demand for Active Management

Abstract

Actively managed mutual funds have distinct return distributions from their passive benchmarks and our theoretical analysis using tail-sensitive risk preferences suggests that active value and growth funds may serve to reduce downside risk and capture upside potential, respectively. Furthermore, tail-sensitivity measures estimated from the empirical pricing kernel have significant explanatory power for active fund flows, even after controlling for business cycles and market-wide sentiment. Finally, active funds, unlike their passive counterparts, have exposures to option strategies hedging downside risk or capturing upside potential.

Keywords: tail-sensitive preferences, probability weighting function, active management, mutual funds

JEL Classification: G11, G23