Mutual Fund Flows and Downside Risk

Abstract

There is little empirical evidence regarding downside risk in asset pricing, due in part to problems inherent in estimating downside risk. We argue that Berk and van Binsbergen (2016)’s approach to testing asset pricing models using the relation between investor flows and risk-adjusted fund returns is well suited for examining the merits of downside risk. We extend the analysis of Berk and van Binsbergen (2016) and Barber et al. (2016) by showing that investors care more about downside market risk than unconditional market risk when choosing mutual funds. Our study provides novel insights regarding investors’ preferences. We find that investors’ sensitivity to downside risk increases following market crises and is more pronounced among funds with conservative investment objectives. Finally, we find that investors’ response to downside risk is not subsumed by information/influence from Morningstar ratings.