Are investors better safe than sorry? The impact of extreme losses in the return distribution on capital allocation in actively managed equity funds

Abstract: In this paper, we show that capital flow to actively managed equity funds is dependent on past extreme negative return states of the fund. Specifically, we examine how an extreme negative monthly payoff impacts the investment flow of actively managed equity funds in the following year, adjusting for past performance and other fund characteristics. Our results indicate that investors make their investment decisions in line with one of the predictions of cumulative prospect theory, namely that investors place excess weight on tail events. As a result, they are less willing to direct investments into funds with an extreme negative payoff in their historical returns as they overweight the probability of similar extreme events in the future. Furthermore, we examine the practical implications of this investor behavior, discussing the impact on fund managers and their portfolio strategy. Our results are robust even when controlling for factors such as historical performance, volatility, fund fees, fund size and company size.