Does MAX matter for mutual funds?

• Author: Haimanot Kassa,Bradley A. Goldie,Tyler R. Henry
• DOI: http://doi.org/10.1111/eufm.12192
• Published date: 01 September 2019
• Date: 01 September 2019

DOI: 10.1111/eufm.12192

ORIGINAL ARTICLE

Does MAX matter for mutual funds?

Bradley A. Goldie

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Tyler R. Henry

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Haimanot Kassa

1,2

1

Farmer School of Business, Miami

University, Oxford, Ohio

Emails: goldieba@miamioh.edu;

henrytr3@miamioh.edu;

kassah@miamioh.edu

2

US Securities and Exchange

Commission, Washington, District of

Columbia

Abstract

Extreme returns (MAX) have been shown to impact future

expected stock returns. We examine whether this relation-

ship 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.

KEYWORDS

lottery preferences, MAX, mutual fund flows and performance,

skewness

JEL CLASSIFICATION

G11, G23

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INTRODUCTION

The empirical asset pricing literature demonstrates that stocks with lottery-like payoffs, as measured by

a stock's maximum daily return over the month (MAX), have low future returns, yet some investors

We thank an anonymous referee and the editor John Doukas. We also thank John Bae, Turan Bali, Fan Chen, Ryan Davis,

Jared DeLisle, Hui Guo, Scott Murray, and participants at the 2016 SFA conference, the 2017 FMA conference, and the

2017 FMA European conference for helpful comments. The authors are responsible for any errors or omissions. The

Securities and Exchange Commission (SEC) disclaims responsibility for any private publication or statement of any SEC

employee or Commissioner. This paper expresses the authors’views and does not necessarily reflect those of the

Commission, the Commissioners, or other members of the staff.

Eur Financ Manag. 2018;1–30. wileyonlinelibrary.com/journal/eufm © 2018 John Wiley & Sons, Ltd.

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777Eur Financ Manag. 2019;25:777–806. wileyonlinelibrary.com/journal/eufm © 2018 John Wiley & Sons, Ltd.

exhibit a preference for stocks with such characteristics (Bali, Cakici, & Whitelaw, 2011). The mutual

fund literature finds that fund investors respond to past performance, documenting a well-known

flow–performance relationship (Chevalier & Ellison, 1997; Sirri & Tufano, 1998). In this paper, we

study whether mutual funds with high MAX characteristics (measured by the fund's maximum daily

return over the month) also have low future returns. After documenting that MAX funds underperform

in both portfolio sorts and cross-sectional tests, we seek possible explanations for this under-

performance. We investigate both the underlying holdings of MAX funds and investor flows into these

funds as potential sources of underperformance. We find support for both mechanisms as contributors

to a MAX effect in mutual fund returns.

At the individual stock level, recent evidence indicates that a stock's maximum daily return during

the month predicts its performance in the following month (Annaert, De Ceuster, & Verstegen, 2013;

Bali et al., 2011; Walkshäusl, 2014). Specifically, portfolios of high MAX stocks underperform

portfolios of low MAX stocks, and this result has been partly attributed to investors’preference for

stocks with a high likelihood of a lottery-like payoff. However, rather than holding individual stocks,

many investors instead choose to invest in managed mutual funds. At year-end 2014, US-registered

investment companies managed over $18.2 trillion in assets, the majority of which ($15.8 trillion) were

held within mutual funds.

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Given the prominence of mutual funds as an investment vehicle, both

the determinants of fund performance and the characteristics that attract flows to mutual funds are

questions of central importance for fund investors and fund managers alike. The underperformance of

high MAX stocks documented by Bali et al. (2011) applies to characteristic-sorted portfolios of

individual stocks formed explicitly based on a stock's MAX measure. A related, but unexplored,

question is whether some mutual funds demonstrate similar MAX-like characteristics, despite not

being formed specifically based on this characteristic. In particular, we are interested in determining if

high MAX mutual funds suffer from poor performance, and whether the preference for lottery-like

payoffs (using MAX as a proxy) carries over to the mutual fund space.

If high MAX mutual funds display the same underperformance as documented for individual

stocks, the mechanism by which this relationship occurs is likely to be different for mutual funds than it

is for stocks. The literature suggests that high MAX stocks underperform due to high investor demand

for these stocks, which leads to lower expected returns (Bali et al., 2011). Due to the nature of

open-ended fund flows, this mechanism does not directly translate to mutual funds. We alternatively

explore two possible explanations for why MAX funds would underperform. The first is related to fund

flows. If investors demonstrate a preference for MAX characteristics in mutual funds, rather than

driving the price up, and subsequent expected returns down, as is the case with stocks, investor demand

would lead to greater fund inflows and assets under management. Berk and Green (2004) show how

decreasing returns to scale in investment ability can erode the performance of mutual funds as they

grow in size. Consistent with the Berk and Green (2004) model, increased flows to mutual funds with

MAX characteristics could lead to future underperformance, relative to funds without this

characteristic. Second, we examine the portfolio holdings of MAX mutual funds. If MAX funds

concentrate their holdings in MAX stocks, then the underperformance of MAX fund returns can be at

least partially attributed to the underperformance of the underlying stocks.

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To aid in this investigation,

we compare the lottery-like characteristics of stocks held by mutual funds to the universe of all stocks

to see if mutual funds concentrate their holdings in a unique subset of high MAX stocks.

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Investment Company Institute 2015 Annual Fact Book (http://www.icifactbook.org/fb_ch1.html). US mutual funds account

for 53% of total worldwide mutual fund and ETF assets.

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We note that these two alternative mechanisms are not mutually exclusive.

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