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Answer the 4 parts question as the word doc. shown!
Compute the standard deviation of the returns of the MKT-portfolio for period 1.Compute the skew of the returns of the SMB-portfolio for period
1.Compute the excess kurtosis of the returns of the HML-portfolio for period 1.Compute the mean of the returns of the RMW-portfolio for period
1.Compute the standard deviation of the returns of the RMW-portfolio for period
1.Compute the standard deviation of the returns of the CMA-portfolio for period 1.Compute the skew of the returns of the CMA-portfolio for period
1.Compute the mean of the returns of the MOM-portfolio for period
1.Compute the standard deviation of the returns of the SMB-portfolio for period 2.Compute the mean of the returns of the CMA-portfolio for period 2.
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Running head: Primus Leasing Case
Term paper project
MET AD 685
Evaluation of a mutual fund using the Fama-French Five-Factor model
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Evaluation of a mutual fund using the Fama-French Five-Factor model
Introduction
It is a general belief that Mutual Fund is a retail product which is so designed for those
who do not directly invest in share market because of its unpredictable and volatile nature, but
fascinated by the growth and returns given by the same market. This term paper seeks to evaluate
a mutual fund with reliance on Fama-French Five-Factor model. The results obtained from this
study will be compared with exchange-traded funds (EFTs) considered to have similar objectives
(Alekhya & Saritha, 2016). Regulators, researchers and market stakeholders are growing interest
about the financial risk of the institutional as well as individual investors when it comes to
investment selection. Mutual funds’ are fixed-income kind of investments that have shown
growth interest with stakeholders in making institutional holdings as well as individual
investments (Alekhya & Saritha, 2016).
The fixed income securities market has expanded rapidly in the investment space more
so with a major boost in institutional holdings. Such interest in fixed income securities has
witnessed shrinking balance sheets for the corporate bond dealers thus limiting their capacity to
make the markets (Kumar & Kumar, 2012).It is expected that the simultaneous buying and
selling by voluminous investors potentially drives asset prices far away from their fundamentals.
Additionally, market participants such as dealers in the investments have been rendered helpless
due to their limited market-making capacity thus exacerbating price distortion (Duffie, 2010).
Financial stability risk is compounded by such investment behaviors which could potentially
cause fluctuation on asset prices (Low & Azlan Ghazali, 2007).
Evaluation of a mutual fund using the Fama-French Five-Factor model
Statement of problem
Investors overtime have held different choices among their investment choices. Uptake of
mutual funds as an investment drive has not achieved the highest levels yet they are promising to
have better returns. The study will seek to address the following problems:
a) Why investors prefer to invest in mutual fund among available investment avenues?
b) Why do investors prefer to choose short term investment in mutual fund?
c) Do the investors know about the risk factors in their mutual fund investment?
d) Why do investor switchover from existing fund to new fund?
Evaluation of a mutual fund using the Fama-French Five-Factor model
Literature review
This part will discuss the relevant literature as well as an economic theory that will
underpin the study. The literature will be scholarly reviewed to help understand the subject in
question and see how the problem may be resolved.
Fama and French Three-Factor Model
The model was developed by Eugene Fama and Kenneth French as a measurement tool
for the market returns. The model is essentially the result of an econometric regression of
historical stock prices. The observations made through thorough research revealed that value
stocks perform better than the growth stocks. At the same time, small-cap securities appear to
perform better than large-cap stocks. The Three-Factor Model makes adjustments accordingly
by looking at the size of the firm, book-to-market values and the excess return in the market. The
following is how it computes the factors: 1. Firm size (small minus big=SMB) 2. Book-tomarket value (high minus low=HML) 3. Portfolio’s return less risk free rate of return. The role of
SMB is to account for the publicly traded companies that have small market capitalization yet
generates higher stocks returns whereas HML is to take care for the value stocks that have high
book-to-market ratios and yet they generate higher returns compared to the existing market. As
to whether the outperformance is due to market inefficiency or market efficient is a subject of
debate. However, those in favor of market efficiency argues that the outperformance is as a result
of excess risk that value and small-cap stocks face due to the higher cost of capital as well as the
associated greater business risks. The proponents of market inefficiency argues that the
outperformance is as a result of market participants incorrectly valuing the companies hence the
excess return in the long run as the value adjusts.
Evaluation of a mutual fund using the Fama-French Five-Factor model
The model is relevant as it highlights investors’ ability to ride out extra short-term
volatility as well as the periodic underperformance that may occur in the short time. As such,
long-term investors who have a long-term time horizon say 15 years plus will be rewarded for
any losses suffered that may occur in a short time. Fama and French used thousands of random
stock portfolios in testing their model (Lakshmi & Roy, 2012). The conclusion arrived at is that
when size and value factors are combined with the beta factor, they are able to explain more than
95% of the return in a diversified stock portfolio. The model is deemed appropriate in this study
as it given the ability to explain 95% of a given portfolio return in the market. Investors may
therefore, construct a portfolio that may give them average expected return according to the
relative risks assumed in their portfolio selection. It is so because the main factors driving
expected returns are the sensitivity to the market, sensitivity to the size and the sensitivity to
value stocks measured by book-to-market ratio. Any additional average expected return may be
attributed to unpriced or unsystematic risk.
Literature review
There is a host of reasons entities or individuals undertakes various investments, it can be
for safety cushion, regular cash needs, for an investment, return of influence or purchase for
control (Cha, 2001). According to Cha (2001) there is no relationship between seasonality of
different earnings and their dispersion. Most research on mutual funds focuses on two
explanatory variables, risk and return. It is therefore, argued that the approach implicitly places
no value on other aspects that may affect decision on mutual fund investment. The strict
economic frame under which mutual funds operate has necessitated need for researchers to
investigate whether or not mutual funds outperform the market. Sharpe and Jensen works shows
that on risk adjusted basis, mutual funds underperforms the market. Recent studies also shows
Evaluation of a mutual fund using the Fama-French Five-Factor model
evidence of potentially high mutual funds returns. Studies that have relied on risk and return
alone concludes that past risk-adjusted mutual fund performance helps in predicting future risk
adjusted performance (Cha, 2001).
It is appreciated that investors make decisions under different circumstances. Empirical
support shows that mutual fund investors make purchase decisions solely on the basis of past
performance. Previous fund performance is associated with net inflows to the mutual fund.
Notwithstanding dominating focus on return and risk, it is evident that return and risk variables
are not sufficient explanations of the mutual fund investment decisions (Kumar & Kumar, 2012).
Evidence that the return and risk are inadequate explanatory variables for mutual fund
investment decisions is documented in the 1990 Consumer Reports survey of the mutual fund
investors. Although mutual fund past performance and level of risk (safety) are rated to be the
two most significant factors in aggregate, several additional factors are also relevant to mention:
amount of sales charge, the management fees, fund manager reputation, fund family, clarity of
the fund's accounting statement, and referrals as well as recommendations.
Because of the distributional nature of these responses, it is quite likely that for some
investors, past performance and level of risk (safety) were not the most important charac...
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