Exposure to Left‐Tail Risk, Risk Appetite, and Mutual Fund Flows

ABSTRACT Using a measure of aggregate tail risk, we show that a fund's sensitivity (exposure) to tail risk negatively affects the fund flows and the fund's performance. Further, a fund's tail risk sensitivity relates positively to the left‐tail risk measures of the fund. We estimate the left‐tail risk measures non‐parametrically using daily fund returns and find that the measures also relate negatively to the funds’ future cross‐sectional investor flows and (cumulative) risk‐adjusted performance. We further find that funds, on average, are slow at changing their left‐tail risk. On examining the portfolio holdings of funds, we find that a fund's left‐tail risk is positively related to the left‐tail risk of individual stocks in its portfolio. Additionally, funds with higher left‐tail risk also hold stocks with higher idiosyncratic risk and skewness. The poor performance of funds with higher left‐tail risk appears to be due to the over‐valuation of stocks in their portfolios. Given the recent finding of a left‐tail return momentum for stocks with high left‐tail risk, mutual funds which continue to hold stocks with exposure to left‐tail risk, underestimate the persistence in left‐tail risk and the associated overpricing.