Do Mutual Fund Investors Overweight the Probability of Extreme Payoffs in the Return Distribution?

We investigate the role of extreme positive payoffs in the distribution of monthly fund returns on investors’ mutual fund preferences. We document a positive and significant relation between the maximum style-adjusted monthly return (MAX) over the previous year’s monthly returns and future fund flows. Our findings are consistent with the idea that fund investors overweight the probability of high payoff states in past return distribution. MAX as a measure of average past fund performance, increase in fund visibility, convex performance-flow relation, underlying stocks’ extreme returns, and MAX as a metric of future performance do not explain our results

Going for Gold

In September 2011 Morningstar launched its qualitative forward-looking analyst ratings to supplement its widely followed backward-looking star ratings. This new system is designed to convey information about a mutual fund’s future performance using a five-tier scale: Gold, Silver, Bronze, Neutral, and Negative. We examine both the investor response to analyst rating initiations and the out-of-sample performance of newly rated funds. We find that investors respond positively to Gold and Silver rated funds relative to other rated funds. We find little evidence that the new rating system identifies funds that outperform peer funds at horizons of up to 6 months. Overall, it appears that rating initiations influence investor allocation decisions, but it remains unclear whether the ratings provide valuable information regarding long-term, out-of-sample performance