Mutual fund performance and flow-performance relationship under ambiguity

Since the exact probability distribution of asset returns is often unknown, the type of uncertainty affecting financial assets may be better characterized as ambiguity rather than risk. Using data from the U.S. mutual fund market, we examine the relationships between mutual funds’ ambiguity exposure, risk-adjusted performance, and investment flows. We introduce a novel measure of ambiguity exposure based on the smooth ambiguity model, which provides insight into how funds are priced in the presence of ambiguity. We find that risk-adjusted fund returns include a positive premium that compensates for greater ambiguity exposure in the fund’s asset holdings. The flow analysis, however, suggests that fund investors pursue positive risk-adjusted returns overall, regardless of whether seemingly superior returns are driven by the ambiguity premium. This behavior indicates that fund investors are primarily attracted to performance outcomes and less concerned with whether these reflect managerial expertise or increased ambiguity exposure. • Do risk-adjusted returns of a fund increase in its ambiguity exposure? • Theoretically yes, according to the smooth ambiguity model. • Empirically yes, in our study of U.S. mutual fund data from 1999 to 2019. • Investors chase high risk-adjusted returns, regardless of performance sources. • They do not discriminate against superior performance due to ambiguity exposure.