Mutual Fund Performance
An analysis of determinants of risk-adjusted performance for mutual equity funds available for Swedish investors
Sandra Carlsson, Erica Eikner
Department of Business Administration International Business Program Degree Project, 30 Credits, Spring 2020
Supervisor: Rickard Olsson
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ii ABSTRACT
The mutual fund industry in Sweden has grown rapidly over the past years. Research has been made on the topic for over 50 years, however there are still uncertainties about the determinants of fund performance. The purpose of this study was to examine what determines the risk-adjusted performance of mutual equity funds available to Swedish investors. A side-purpose was included to examine to what extent the Efficient Market Hypothesis holds in Sweden. A simple random sample was conducted where 500 equity funds were included. From Refinitiv/Thomson Reuters Eikon Datastream fund characteristics were downloaded. To find the abnormal return of mutual equity funds, a hybrid Fama-French Carhart factor model was used which includes both domestic Swedish factors and global factors. The model was used to calculate the yearly risk- adjusted performance for each fund using 12 months return. This was denominated Alpha which was used as the dependent variable in the regression models. Further, to determine the characteristics which affect risk-adjusted performance two multiple regression models with six independent variables and three control variables are constructed. Further, a one sample t-test was conducted to test the market efficiency for mutual funds available to Swedish investors. Eight statistical hypotheses were created and tested in which two found a significant result which were that alpha differs from zero and Total Expense Ratio determines the risk-adjusted performance.
To conclude, findings showed only the character Total Expense Ratio determines risk- adjusted performance of mutual equity funds available to Swedish investors. In conclusion the control variables year, geographical focus and currency affect the fund performance. The study is an interesting aspect for Swedish investors and fund managers since the study implies deeper knowledge about the mutual fund industry in Sweden and therefore should be concerned by the variable TER to earn abnormal returns. Further, the study contributes with a theoretical discussion in line with the results concerning Efficient Market Hypothesis, the Diversification Effect and Modern Portfolio Theory. Conclusions are drawn based on our result that the Efficient Market Hypothesis does hold in the Swedish fund market. Although only one character determines the risk-adjusted performance and average investor should choose funds that follow the market, based on the skill level of average investors.
Keywords: Mutual equity funds, risk-adjusted performance, Total Expense Ratio, fund characteristics, Swedish investors, Efficient Market Hypothesis, Sweden, Carhart four
factor model
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ACKNOWLEDGEMENTS
We would like to thank our supervisor Rickard Olsson for all the support and constructive feedback in the writing process. Further, we thank Rickard Olsson for the help and assistance in the statistics and data collecting process. We also thank our friends, family and student colleagues for the support along the thesis. Lastly, we would also like to thank each other for outstanding teamwork.
Umeå, 25.05.2020
Sandra Carlsson & Erica Eikner
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TABLE OF CONTENTS
1. Introduction ____________________________________________________________________________ 1 1.1 Problem background ____________________________________________________________________ 1 1.2 Problem discussion ______________________________________________________________________ 2 1.3 Research question ________________________________________________________________________ 4 1.4 Purpose ____________________________________________________________________________________ 4 1.5 Perspective of the Study _________________________________________________________________ 5 1.6 Preconceptions ___________________________________________________________________________ 5 1.7 Theoretical and practical contribution _______________________________________________ 6 1.8 Delimitations ______________________________________________________________________________ 6 2. Literature review/ Theoretical Point of Reference ________________________________ 8 2.1 Previous research ________________________________________________________________________ 8 2.2 Summary of previous research _______________________________________________________ 12 3. Theoretical framework ________________________________________________________________ 13 3.1 Mutual funds ____________________________________________________________________________ 13
3.1.1 Mutual equity funds ___________________________________________________________________________ 13
3.1.2 Index funds ____________________________________________________________________________________ 13
3.1.3 Actively managed funds ______________________________________________________________________ 13
3.1.4 Return __________________________________________________________________________________________ 14 3.2 Theories in Finance ____________________________________________________________________ 14
3.2.1 Modern Portfolio Theory _____________________________________________________________________ 14
3.2.2 Diversification effect __________________________________________________________________________ 15
3.2.3 Capital Asset Pricing Model and Jensen’s alpha _____________________________________________ 15
3.2.4 Fama French Three Factor Model ____________________________________________________________ 16
3.2.5 Momentum effect _____________________________________________________________________________ 16
3.2.6 Carhart Four Factor Model ___________________________________________________________________ 16
3.2.7 Efficient market hypothesis (EMH) __________________________________________________________ 17
3.2.8 Joint Hypothesis (problem) __________________________________________________________________ 18 4. Scientific method ________________________________________________________________________ 19 4.1 Ontological consideration _____________________________________________________________ 19 4.2 Epistemology ____________________________________________________________________________ 19 4.3 Research strategy _______________________________________________________________________ 19 4.4 Research approach _____________________________________________________________________ 20 4.5 Source criticism _________________________________________________________________________ 20 4.7 Ethical and societal considerations __________________________________________________ 21 5. Research method ________________________________________________________________________ 22 5.1 Random Sample _________________________________________________________________________ 22
5.2 One sample t-test _______________________________________________________________________ 22 5.3 Regression Analysis ____________________________________________________________________ 23 5.4 Multiple regression analysis __________________________________________________________ 23 5.5 Regression Coefficients ________________________________________________________________ 23 5.6 Variables _________________________________________________________________________________ 24
5.6.1 Omitted variables _____________________________________________________________________________ 24
5.6.2 Dependent Variable ___________________________________________________________________________ 24
5.6.3 Independent Variables ________________________________________________________________________ 24
5.5.4 Control variables ______________________________________________________________________________ 27 5.7 Regression models _____________________________________________________________________ 28 5.8 Statistical Hypotheses _________________________________________________________________ 29 5.9 Two-sided t-test _________________________________________________________________________ 29 5.10 Critiques to method __________________________________________________________________ 30 6. Data ________________________________________________________________________________________ 31 6.1 Data and sample ________________________________________________________________________ 31 6.2 Survivorship bias _______________________________________________________________________ 31 6.3 Data collecting method ________________________________________________________________ 32 6.4 Alpha calculation _______________________________________________________________________ 32 6.5 Descriptive statistics ___________________________________________________________________ 33 6.6 Ordinary least squares (OLS) assumptions _________________________________________ 38
6.6.1 Linearity (assumption I) ______________________________________________________________________ 38
6.6.2 The error term (assumption II, III & VII) ____________________________________________________ 39
6.6.3 Autocorrelation (assumption IV) ____________________________________________________________ 39
6.6.4 Heteroskedasticity (assumption V) __________________________________________________________ 40
6.6.5 Multicollinearity (assumption VI) ___________________________________________________________ 40 6.7 Adjusted regression model ___________________________________________________________ 41 7. Empirical results ________________________________________________________________________ 42 7.1 One Sample t-test result _______________________________________________________________ 42 7.2 Regression results ______________________________________________________________________ 42 7.3 Hypothesis summary __________________________________________________________________ 48 8. Analysis and discussion ________________________________________________________________ 49 8.1 Analysis of results ______________________________________________________________________ 49
8.1.1 Test of EMH ____________________________________________________________________________________ 49
8.1.2 Total Expense Ratio and performance ______________________________________________________ 49
8.1.3 Size and Performance _________________________________________________________________________ 50
8.1.4 Age and Performance _________________________________________________________________________ 50
8.1.5 Gender and performance _____________________________________________________________________ 50
8.1.6 Management structure and performance ___________________________________________________ 51
8.1.7 Ethical criteria and performance ____________________________________________________________ 51
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8.1.8 Index funds and performance ________________________________________________________________ 51
8.1.9 Control variables and performance __________________________________________________________ 51 8.2 General discussion _____________________________________________________________________ 52 9. Conclusion and future research ______________________________________________________ 54 9.1 Conclusion _______________________________________________________________________________ 54 9.2 Truth criteria of the research ________________________________________________________ 54
9.2.1 Reliability ______________________________________________________________________________________ 55
9.2.2 Validity _________________________________________________________________________________________ 55
9.2.3 Generalizability ________________________________________________________________________________ 55 9.3 Societal and Ethical Implications ____________________________________________________ 56 9.4 Theoretical and Practical Contribution _____________________________________________ 56 9.5 Future research _________________________________________________________________________ 57 Reference list _______________________________________________________________________________ 59 Appendix _____________________________________________________________________________________ 65 Appendix 1: Regression 2 __________________________________________________________________ 65
LIST OF TABLES
Table 1: Summary of previous research_____________________________________12 Table 2: Descriptive statistics_____________________________________________34 Table 3: Descriptive statistics variable FMMGM______________________________34 Table 4: Descriptive statistics variable SOLO_________________________________35 Table 5: Descriptive statistics year_________________________________________35 Table 6: Descriptive statistics gfocus_______________________________________36 Table 7: Descriptive statistics currency______________________________________37 Table 8: Correlation matrix_______________________________________________38 Table 9: Wooldridge test_________________________________________________40 Table 10: Variance inflation factor_________________________________________41 Table 11: One Sample t-test______________________________________________42 Table 12: Regression 1__________________________________________________42 Table 13: Regression 2__________________________________________________44 Table 14: Comparison of regression models__________________________________45
LIST OF FIGURES
Figure 1: Residuals vs fitted values of the regression with alpha as the dependent
variable______________________________________________________________39
LIST OF EQUATIONS
Equation 1: Capital Asset Pricing Model_____________________________________16 Equation 2: Fama-French Three Factor Model________________________________16 Equation 3: Carhart Four Factor Model______________________________________17 Equation 4: Multiple Regression, with K Independent Variables__________________23
Equation 5: Regression model 1___________________________________________28 Equation 6: Regression model 2___________________________________________28 Equation 7: Hybrid Fama-French Carhart Factor Model_________________________32
LIST OF ABBREVIATIONS (CAPM) Capital Asset Pricing Model
(Eikon) Refinitiv/Thomson Reuters Eikon Datastream (EMH) Efficient Market Hypothesis
(ETF) Exchange traded fund (HML) High-minus-low
(ISIN) International securities identification number (MOM) Momentum
(MPT) Modern Portfolio Theory (NAV) Net asset value
(OLS) Ordinary least squares (RI) Total return index
(SCB) Statistiska centralbyrån, Central bureau of Statistics (SMB) Small-minus-big
(TER) Total Expense Ratio (TNA) Total Net Assets (VIF) Variance inflation factor
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1. Introduction
This chapter will include the introduction, problem background and problem discussion of the chosen topic. There will be an explanation why the chosen area is a relevant and interesting topic in Business Administration. The area presented is the mutual equity fund industry in Sweden funds. Previous studies from researchers and student theses will be presented about the mutual equity fund performance and its characteristics. Further, the research question and the purpose of conducting the study will be presented. In addition, the perspective of the study, preconceptions, theoretical and practical contribution and lastly delimitations will be discussed.
1.1 Problem background
Investments in mutual funds are an important part of the financial sector and have increased over the last decades (Anderson & Ahmed, 2005, p. 1). Research before argues the importance of understanding the performance of mutual funds (Ferreira et al., 2012, p. 1759). Therefore, performance evaluation on mutual funds has been made over a period of time (Anderson & Ahmed, 2005, p. 13). An increase in activity in the mutual fund industry in Sweden has been acknowledged for investors in the age 18-74 years from 62 percent in 1998 to 76 percent in 2012 (Kopsch et al., 2015, p. 10). Today this is the most common form of investment and saving in Sweden, with 8 out of 10 people investing in mutual funds (Fondbolagens Förening, n.d.). In general, Gruber (1996, p. 784) explains the growth in mutual funds leads to more people becoming more active in the mutual fund industry. Additionally, Chen et al. (2004, p. 1276) argues the importance of investing in funds since it is a fast-growing industry. This contributes to more people becoming interested in the mutual fund industry.
We also believe the mutual fund industry is a relevant area to investigate in terms of Business Administration. The topic is interesting since many people are affected by mutual funds considering their savings and pension and is therefore a topic that needs to be further researched. Moreover, the relation between fund characteristics and its performance is complex and, from the investor's point of view, the topic is still current and further research is important to present the updated information about the risk- adjusted return of mutual fund performance in terms of their characteristics.
Several studies have been made on the US market, however it can be seen that Swedes’
interest in investing in funds have increased and less research has been made on the Swedish mutual fund market (SCB, 2018). According to SCB (2018) the Swedish fund market had in 2018 more deposits into the fund market than withdrawals. A reason for the increase in total fund assets in 2018 was due to the positive market development (SCB, 2018). The increase from 2017 to 2018 was 42 billion SEK and a total of fund wealth was registered at 3 804 billion SEK in 2018 (SCB, 2018). This shows an interest to further investigate the Swedish market since it can be argued the mutual equity funds play an important role in the financial market and most common form of fund investment (Metrick & Yasuda, 2010, p. 2304).
A discussion whether to invest in index or actively managed funds is a current topic and in 2014, actively managed funds in Sweden were still the most popular investment choice for the investor (Pettersson & Hård af Segerstad, 2014, p. 7). However, index funds’ value
have increased in the 2010s in Sweden (Pettersson et al., 2019, p. 15). Therefore, it can be argued the fund's characteristic, whether the fund is indexed or actively managed, is highly important to consider to determine the risk-adjusted performance of mutual equity funds. Further research needs to be conducted concerning which type of fund performs best in Sweden. Pettersson and Hård af Segerstad (2014, p. 12) mention that index funds should perform better than the market index in the long run. However, a problem could be that the efficient market hypothesis does not hold to a great extent, which will be discussed in the problem discussion (Pettersson & Hård af Segerstad, 2014, p. 12). Further discussions about the characteristics of mutual equity funds and different previous studies in the area will be discussed. The difficulties to choose the actively managed funds have decreased over the years and the complexity of it can be explained by that before the actively managed funds were seen as a homogeneous group and their performance were compared with the market index (Pettersson & Hård af Segerstad, 2014, p. 18). This is an interesting aspect and based on our study this will be further researched if this is the case.
According to Pettersson and Hård af Segerstad. (2014, p. 18) the factors that explain the fund performance needs to be determined. It is important for an investor to be aware of the factors in order to make the best decisions on how to successfully invest in mutual funds and therefore it is important to give deeper knowledge to the investors (Pettersson
& Hård af Segerstad, 2014, p. 20). Additionally, Barber et al. (2016) argue that investors who invest in mutual funds should consider all factors that explain the variation in fund performance.
1.2 Problem discussion
Several studies have been made about mutual fund performance on the US market and European market, but there is less research made focusing only on the Swedish market.
According to Ferreira et al. (2012, p. 1759) the non-US markets have become influential in the mutual fund industry. Therefore, this indicates a relevant topic for us to further conduct a study upon.
Previous studies show that US funds are different compared to non-US funds because of the funds size, meaning US funds can be up to five times larger than non-US funds (Ferreira et al, 2013, p. 488). Further, the US market is more established and their funds are older (Ferreira et al, 2013, p. 488). Since there is much research made on the US market, it would be interesting to only investigate the Swedish market. Moreover, the Swedish mutual fund market has increased over the years which shows high relevance to further investigate the Swedish mutual equity fund market. Equity funds are important to be considered since these funds play a vital role in the financial sector (Metrick & Yasuda, 2010, p. 2304). Previous research argues the difficulty to determine the characteristics in which describe the fund performance (Ferreira et al., 2013, p. 484). Since previous researchers have found different results about mutual equity fund characteristics in relation to fund performance this still indicates a relevant and interesting area to conduct our thesis upon.
Research made by Jensen (1968, p. 415) and Gruber (1996, p. 783) conclude that actively managed mutual funds on average underperform the market. A study made by Otten and Thevissen (2011, p. 17) concludes a positive relation of active funds and performance.
Therefore, it can be argued this is still a knowledge gap and it is interesting to gain more knowledge about the Swedish market whether index or actively managed funds perform better. Additionally, a study by Dahlquist et al. (2000, p. 422) concludes that in the Swedish mutual fund industry, actively managed funds perform better than passive funds.
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This is an interesting perspective to take a further step to include whether index or actively managed funds perform better.
Several researches show a negative relationship between size and performance in the US market, this is addressed in studies by Chen et al. (2004, p. 1282), Otten and Bams (2002, p. 84) and Ferreira et al. (2013, p. 485). Ferreira et al. (2013) made a cross sectional study where, in the US, smaller funds perform better than larger funds, however considering the European market Ferreira et al. (2013, p. 484-485) non-US funds showed a positive relationship with size. This is interesting to incorporate into our study since different results are presented. The study made in Sweden by Dahlquist et al. (2000, p. 419) finds a negative relationship between size and performance in Sweden. The years presented were 1993-1997 (Dahlquist et al., 2000). However, we believe that there is a need for recent updates, and this shows relevance to further investigate the Swedish mutual equity fund market. Another variable that has been studied before is the expense ratio. According to Gruber (1996, p. 794) and Sharpe (1966, p. 133) a low expense ratio leads to better performing funds.
Chen et al. (2004, p. 1297-1298) and Ferreira et al. (2013, p. 486) conclude that solo managed funds outcompete the team managed funds. Therefore, it would be interesting to only investigate the Swedish market concerning this variable since no study before, what we have seen, have considered this characteristic of Swedish mutual fund performance. Moreover, fund age will be included as a variable in relation to fund performance. We believe this would be an interesting variable to include in the study since previous studies on the age variable have come up with different results. Moreover, we have not found any studies made only on the Swedish mutual equity fund market where fund age has been considered. A study by Ferreira et al. (2013, p. 486) concludes a statistically significant relationship between fund age and fund performance for non-US funds. The study shows that younger funds perform better than older funds (Ferreira et al., 2013, p. 486). However, for US funds a statistical insignificant relationship between fund age and fund performance is found (Ferreira et al., 2013, p. 486). Therefore, this variable is interesting to include only on the Swedish market to investigate further how the case is for the mutual equity funds sold in Sweden.
One previous student thesis studied the relation between fund performance and some attributes of the mutual funds (Bergström & Sunden, 2008). Bergström and Sundén (2008) study the period 2003-2007. The study has made a research on 90 funds on the Swedish market (Bergström & Sundén, 2008, p.1). The study investigates the variables alpha, size coefficient, the flow coefficient and fund management fee (Bergström &
Sundén, 2008). From our point of view, it is interesting that the previous student thesis has investigated this topic, however we believe additional variables need to be included to investigate the relation between mutual equity funds risk-adjusted performance and its characteristics. Therefore, we argue for a knowledge gap in this topic and further characteristics need to be included in terms of mutual equity fund performance.
One previous study has examined whether gender of the fund manager affects the performance of mutual funds (Cuthbertson et al., 2016). Therefore, we believe a gender variable would be interesting to include since this variable may have an effect on the fund performance in Sweden.
Moreover, previous studies and student theses engage the problem before or during the financial crisis in 2008 (Bergström & Sundén, 2008; Andersson & Hamilton, 2015). We argue a more recent update needs to be conducted in the mutual fund industry and mutual fund performance in Sweden. We aim to investigate the problem by broadening the time period, specifically 2003-2019.
The market efficiency theory has been established for a long time (Fama, 1970) and has been challenged by previous researchers (Makiel, 2003; Beyhaghi & Hawley, 2013).
Some previous researchers conclude that the efficient market hypothesis (EMH) does hold to a great extent where no abnormal returns can be achieved (Fama & French, 2010, p. 1916). However, several researchers show that the market is inefficient, and thus that the EMH does not hold (Makiel, 2003, p. 80). This theory is an interesting aspect of our study and will be questioned since the efficient market hypothesis is up for debate. The EMH will be tested. If the EMH does not hold investors have the power in the Swedish mutual equity fund market to choose investment strategies and this will present theoretical and practical knowledge and contribution to the investors in Sweden.
As mentioned before, we believe there is still a knowledge gap on this topic. Therefore, we see relevance to investigate the Swedish mutual equity funds in a longer and more recent time period, specifically 2003-2019. Moreover, this study will incorporate more variables. We are aware there is much research made on this topic around the world.
However, since there are differences in Swedish mutual funds it is interesting to conduct further research on the Swedish market and with a Swedish investor perspective.
Furthermore, different results have been presented by previous researches which makes it further interesting to continue research the mutual fund performance in terms of their characteristics. This topic can always be updated with time and therefore the continuous research in the area is necessary. Moreover, many studies have focused on only actively managed funds, however we will also include index funds. The thesis will contribute to further investigating the Swedish market on mutual equity funds to contribute to further knowledge to the investors in Sweden.
1.3 Research question
What determines the risk-adjusted performance of mutual equity funds available to Swedish investors?
1.4 Purpose
The Swedish mutual fund industry has increased in popularity over the years which makes it interesting to further investigate the area. As mentioned before, the characteristics and the mutual fund performance has shown complexity, therefore there is a relevance to contribute with further research in the area. Further, few studies have been made on the Swedish mutual equity fund market which makes it relevant to only focus upon Swedish investors and funds sold in Sweden. The purpose of the thesis is to examine what determines the risk-adjusted performance on Swedish mutual equity funds. This indicates the research question will determine which characteristics affect mutual equity funds in Sweden. The period of investigation will be 2003-2019. A side purpose will be included regarding to what extent the Efficient Market Hypothesis holds in Sweden. With this side purpose the aim is to see whether a Swedish investor can achieve abnormal return by choosing funds based on their characteristics. To fulfill the purpose a quantitative analysis
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will be conducted where we hope to gain a better understanding and knowledge about the determinants of risk-adjusted performance of mutual equity funds in the Swedish fund market between 2003-2019.
1.5 Perspective of the Study
This study is for the perspective of the Swedish investors who invest in the Swedish mutual equity fund market. Since the purpose with this study is to find which factors determine mutual equity fund performance it is a vital part for the investors to acknowledge the characteristics and their effect on the risk- adjusted performance on Swedish mutual equity funds. This is an interesting perspective to the investors and the study will question the EMH, meaning that if the EMH holds the investors cannot have the power to choose the mutual funds to invest in regarding its characteristics to earn abnormal returns. However, if a statistical significance relationship is found between mutual equity fund performance and its variables it can be argued an investor can gain higher risk-adjusted performance on the funds depending on which characteristic the funds acquire. Depending on the results, an investor may then, for example, choose a fund that has a low expense ratio, a male fund manager, solo managed fund, younger fund or smaller fund if these variables will show a statistically significant relationship in terms of the risk-adjusted performance of the mutual equity fund. Therefore, this study is interesting for the perspective of the investors. Another perspective of the study is to give knowledge, further research and inputs for the researcher in the development of new theory and knowledge in the area. In addition, the study is for the perspective of the fund manager of the funds since the study can provide a deeper knowledge of the determinants of risk-adjusted performance for Sweish mutual equity funds. Lastly, the society is considered as a perspective of the study since successful investments increase the living standards of the Swedish people, which brings a stronger economic situation in Sweden.
1.6 Preconceptions
We both are fourth year students at the International Business Program at Umeå University. This thesis is written on an advanced level of Business Administration. Both of us have a major in finance and have had several courses in financial management.
Further, the program has included courses in statistics and economics which will both be of use when writing the thesis. One of the students has taken additional courses in economics and econometrics, giving more knowledge about the process of regressions.
The other student has worked on the side with auditing, and thus has an insight of businesses and their operations.
Finance and financial markets have always been a part of our interest and have only grown with our increased knowledge about the subject. This study will give us more insight about one of the most popular investment forms in Sweden (Fondbolagens förening, n.d).
Therefore, this area is of high relevance to investigate since we both are active in investing and we aim to increase our understanding and knowledge in this area since it is an important aspect when we will in the future continue our investment strategies in mutual funds.
1.7 Theoretical and practical contribution
As the mutual fund industry in Sweden has increased in popularity over the years, it is vital to still further investigate the area. Several studies have been made on this area, still it is complex to examine the relationship between funds characteristic and fund performance. Therefore, we believe it is important to further investigate the area and give more knowledge and understanding to the investors. There may still be other variables that affect the fund performance which have not been investigated and it is of importance to include more variables in the relationship between fund characteristics and fund performance. The practical implications of this study are to help Swedish investors in mutual equity funds to be more aware of which characteristics to take into account when choosing which mutual equity funds to invest in order to earn abnormal returns.
Moreover, managers of funds can have our findings in mind when selecting their portfolio and apply trading strategies. From the investor's point of view, they will be more informed what type of fund to choose depending on its characteristics and the results will present, from a historical point of view, what an investor should choose when choosing mutual equity funds to invest in in terms of the future. If conclusions can be drawn that there is a significant relationship between a variable and fund performance, it is important for the investors to be acknowledged for their ability to earn abnormal return.
The theoretical contributions of this study are to further close the gap in the theory of which variables affect mutual fund performance, specifically in Sweden give theoretical contributions (Dahlquist et al. 2000). The study will examine if the mutual equity fund market in Sweden is efficient. Since the EMH has been challenged by several researches it can be further investigated (Makiel, 2003, p. 80). If we conclude an inefficient market, the study will present which variables that affect the risk-adjusted return. Additionally, the research can be used to build new theories for valuation of mutual equity funds. The thesis will start further discussion and combine theoretical theories that can further explain it. We will also contribute to a theoretical discussion regarding the EMH, whether it holds or not. Since several researchers argue against the EMH and some argue for. The EMH is widely discussed and this study can give further theoretical discussion about the EMH.
Through this study we aim to get a wider understanding about fund characteristics in terms of fund performance. Our aim is to be able to answer the research question and increase investors’ knowledge in fund performance.
1.8 Delimitations
The aim of this study is to provide information to investors about mutual equity fund characteristics and to determine which variables affect risk-adjusted performance of mutual equity funds. The delimitations of the study may be that we only choose equity funds and do not consider other types of funds for example money market funds, hedge funds, bond funds. However, we believe this will give a broad perspective and is the most relevant fund to study looking at the investors point of view. In this study more advanced statistics could have been used. To limit our data the time period 2003-2019 has been used. However, a delimitation could be the time period can be too short and a longer time period would be appropriate, although we believe this time period is enough to be able to answer the research question. Also, there might be difficulty to find all the variables for the study, which may lead to some variables not being included in the study which may
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have an impact on the mutual equity fund performance, which we then will miss in our study. A large sample will be used, however this can lead to limitations such as difficulty to collect the data and errors can occur leading to miscalculations of the data. Another issue might be that when looking at Swedish funds that invest in foreign markets, there might be a problem with the different tax systems and tax benefits. Therefore, taxes will be excluded, and this means it can be difficult to draw quantitative conclusions from it.
Some variables may not be found for certain funds leading to exclusion of these funds which can be a limitation since these may affect the results of the funds. It needs to be considered that these effects may then be captured in other variables or the error term.
Lastly, a delimitation is the data collecting source which in this study Refinitiv/Thomson Reuters Eikon Datastream (Eikon) will be used, there is a need to be critical to the database since all variables may not be presented. Even though we need to be critical to Eikon, we still believe it is a relevant database to access information from the mutual funds and we are confident to a great extent the information is confidential and reliable.
2. Literature review/ Theoretical Point of Reference
In this chapter previous research of the chosen area will be presented. The previous studies have given us inspiration to further investigate the chosen area. This has provided us with a research gap where our aim is to fulfill the purpose and develop further knowledge within the area.
2.1 Previous research
Already in 1966, Sharpe (1966) did a study on mutual fund performance. Findings from the study showed a positive relationship between low expense ratios and fund performance (Sharpe, 1966, p. 132). Moreover, Sharpe (1966, p. 133) investigated if fund size affected fund performance and found a positive relationship, although not statistically significant. Sharpe (1966) argued if the market is not efficient, bigger funds can access more resources, achieve better analysis and spend less of their income on the analysis (Sharpe, 1966, p. 131). Therefore, if the market is efficient those funds which spend the least should show the best performance (Sharpe, 1966, p. 131). However, Sharpe (1996) argued that larger funds require more analysis (Sharpe, 1966, p. 131). Fund performance can be due to differences in management or expense ratios (Sharpe, 1996, p. 131). The largest factor for fund performance in the study was the expense ratio and the Treynor index (Sharpe, 1966, p. 134). Sharpe concluded by comparing funds to an index and showed that nineteen of the funds perform better than the index, and fifteen perform worse. Thereby, no conclusions were drawn whether mutual funds underperform or over perform the market (Sharpe, 1966, p. 137). The study from Sharpe has provided insight and knowledge about mutual fund performance and therefore shows a great relevance to include this in our study. Whether mutual funds underperform or overperform the index variable is an interesting perspective into our study, since a majority of the previous studies presented below conclude that index funds perform better. The study has also given us inspiration to include the expense ratio since Sharpe (1966, p. 134) argued the expense ratio is one of the largest factors for fund performance.
Jensen (1968) did a study on the mutual fund performance in the period 1955-1964. The sample was 115 open end mutual funds (Jensen, 1968, p. 396). Jensen argued the difficulty to measure the performance of the portfolio which is explained by the difficulty of understanding and measuring risk (Jensen, 1968, p. 396). Findings in the study concluded that the 115 mutual funds were not, on average, able to predict security prices such that it would be able to outperform a buy-the-market-and-hold policy (Jensen, 1968, p. 415). Jensen (1986, p. 415) concluded that mutual funds underperform the market.
Since Jensen (1986, p. 415) concluded the opposite result from what Sharpe (1966, p.
137) did where no conclusions can be drawn regarding index and actively managed funds, this will be an important perspective into our study.
A study made by Ippolito (1989) was conducted about mutual fund performance of 143 mutual funds between 1965 and 1984 in the US. The findings of the study concluded that mutual funds, when subtracting fees and expenses, performed better than index funds (Ippolito, 1989, p. 20). Ippolito (1989, p. 21) discussed the limitations about the time period of data, since yearly performance-data was used which is also an issue we need to consider when conducting our study. Further, he argued that if the market is efficient
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active funds should access higher return than index funds in order to pay for the extra expenses (Ippolito, 1989, p. 2). As the side purpose in this study is to examine the efficiency of the Swedish Market this is an interesting aspect. This has also given us the inspiration to continue further research on the Efficient Market Hypothesis. Ippolito (1989, p. 3) concluded that there is little evidence that turnover, fees, expenses are correlated with worse returns, excluding fees and expenses. The method used in the study was to test if the alphas are significantly positive or negative (Ippolito, 1989, p. 6). This is an inspiration to our study to find the alpha for the funds and its characteristics. The study concluded that there are no fees, expenses and turnover ratios that did not have a statistically significant relationship with alpha (Ippolito, 1989, cited in Fama, 1991, p.
1605). This is an interesting perspective to our study that the results could present a non- statistical significance between the variables and fund performance.
Another research by Gruber (1996, p. 783) discussed the increased popularity of actively managed mutual funds even though he argued that index funds perform better. According to Gruber this can be explained by the pricing because funds were sold at net asset value (Gruber, 1996, p. 784). He argued that performance is predictable due to the management ability that exists which is not included in the price (Gruber, 1996, p. 784). The findings of the study showed that investors should buy funds that have low expense ratios (Gruber 1996, p. 794). The study gave us inspiration to include the expense ratio variable in our study. Also, considering the method, performance has been calculated with monthly return which has given us the inspiration to collect monthly data.
A study about the Swedish mutual fund industry was made in 2000 by Dahlquist et al.
(2000). The study included funds from 1993 to 1997 (Dahlquist et al., 2000, p. 410). Some of the fund characteristics studied were size, expense ratio, past performance and flows (Dahlquist et al., 2000, p. 409). The study included equity funds, money market funds and bond funds and excluded funds investing in foreign countries (Dahlquist et al., 2000, p. 411). The results showed that size has a negative relationship with performance (Dahlquist et al., 2000, p. 419). A negative relationship between fee and performance was concluded (Dahlquist et al., 2000, p. 419). Furthermore, findings showed that actively managed funds perform better than passive funds (Dahlquist et al., 2000, p. 422). This study is interesting since it only focuses on the Swedish market, thus being an important perspective and inspiration to further investigate the Swedish market. Also, the time span was different from ours, and this can be an interesting aspect to see if there will be different results for the different years in Sweden. However, the study includes different types of funds, in this case we argue for only included equity funds due to different funds being built up differently and equity funds most common for the average investor.
Moreover, the study has given us inspiration to include a geographical focus in which country the fund is sold, since Dahlquist et al. (2000) does not consider this variable. We believe it would be an interesting aspect to include this variable. Also, conclusion made that active managed funds perform better than passively, which makes it interesting to go further to examine whether index or active funds perform better in Sweden.
A study is made on the mutual fund industry in Europe by Otten and Bams (2002). The study researched the years 1991-1998 (Otten & Bams, 2002, p. 79). The number of funds in the study was 506 from different European countries (Otten & Bams, 2002, p. 75).
Findings showed that smaller funds excessed higher returns (Otten & Bams, 2002, p. 84).
Conclusions were drawn with a negative relationship with expense ratio, however no significant relationship was found (Otten & Bams, 2002, p. 99). Looking at persistence
in mutual fund performance in Europe, France and Germany are weak while Italy shows strong persistence (Otten & Bams, 2002, p. 96). The UK funds show significant results from the persistence analysis and are lowered by excluding momentum effects (Otten &
Bams, 2002, p. 96). According to Otten and Bams (2002) a reason why they are weak and significant for other countries in Europe could be due to a smaller number of funds, which we need to consider to allocate the required amount to be able to investigate it. A negative relationship between age and risk-adjusted performance were presented, however only a significant result was presented for UK and Germany funds, all other results were insignificant (Otten & Bams, 2002, p. 99). This study will give us a perspective that these results may differ in countries and therefore it gives us the inspiration to only focus on the Swedish fund market. Moreover, the study has given us the inspiration to include size and age as variables.
Chen et al. (2004) did a study on mutual equity funds performance in the US between 1962 and 1999. The study applied regression models to determine fund characteristics in relation to fund performance. Findings from the study showed that fund size had a negative relationship with fund performance (Chen et al., 2004, p. 1282). Further, the negative relationship between fund size and fund performance can be explained by the liquidity hypothesis, where bigger funds are more liquid which increases their confidence and thus act more passive than smaller funds (Chen et al., 2004, p. 1289-1299).
Conclusions were drawn that expense ratio and fund performance had a negative relationship (Chen et al., 2004, p. 1287). Age and fund flow did not have a statistically significant effect (Chen et al., 2004, p. 1287). Considering management structure, a conclusion was drawn that team-managed funds underperform compared to solomanged funds (Chen et al., 2004, p. 1297-1298). This study has given us inspiration to include the characteristics of management structure.
Koellner et al. (2005, p. 54-55) argue the sustainability focus has increased in the financial environment. Investors have become more aware of social and ecological consideration when investing in funds (Koellner et al., 2005, p. 54). This has led to an increase in funds having a sustainability rating (Koellner et al., 2005, p. 55). On the other hand, the study argued the difficulty for investors to know the different sustainable ratings (Koellner et al., 2005, p. 55). The study also mentioned that funds don't necessarily increase fund performance due to ecological impact (Koellner et al., 2005, p. 60). Since sustainability has become a current topic and is more considered by investors, the study has given us the inspiration to include a sustainability rating in relation to fund performance.
A study made by Fama and French (2010) investigated active equity funds in the US and their abnormal returns. The study concluded that it is difficult for active funds to achieve benchmark-adjusted return when costs are included (Fama & French, 2010, p. 1917).
However, they argued some managers may have the skill to cover the costs, but it is difficult (Fama & French, 2010, p. 1941). However, when only net returns are considered the active funds, looking at long performance it can be argued that alpha is negative for most active funds (Fama & French, 2010, p. 1916). This means that EMH holds to a great extent, however this study has given the inspiration to test if this is the case on Swedish fund market.
A study made by Otten and Thevissen (2011) further investigated the mutual equity funds in Europe between 1992 and 2006. In this study a conclusion was drawn that actively managed funds performed better than passive managed funds in Europe (Otten &
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Thevissen, 2011, p. 17). Further, size had a positive relationship with fund performance (Otten & Thevissen, 2011, p. 35). Since opposite reuslt were shown between sixe and fund perfroamce it brings further discussion about the size variable.
Ferreira et al. (2013, p. 484) did a study on the determinants of actively managed mutual fund’s performance across 27 countries, Sweden included. The study focused on funds which invest in their domestic markets (Ferreira et al., 2013, p 484). In the study the Carhart Four Factor Model was used to measure the risk-adjusted performance (Ferreira et al., 2013, p. 484). Some variables used in their study are fund and family size, age, fees and expenses, management structure and number of countries funds are being sold (Ferreira et al., 2013, p. 484). It was concluded that US funds and funds in other countries differ since the US funds industry is larger and older than other countries' fund market industry (Ferreira et al., 2013, p. 484). The findings showed that smaller funds perform better than larger funds in the USA, however they address the opposite for some other countries whereas for non-US funds a positive relationship was found (Ferreira et al., 2013, p. 485). Further, Ferreira et al. (2013, p. 503) found some evidence for non-US funds that the expense ratio has a negative relationship with fund performance. Fund age in relation to fund performance was investigated in this study, the results presented showed a statistically significant negative relationship between age and fund performance, where younger non-US funds perform better (Ferreira et al., 2013, p. 486).
Also, as Chen et al. (2004, p. 1297-1298) concluded, this study presented that solo managed funds perform better than team managed funds (Ferreira et al., 2013, p. 486).
This can be explained due to hierarchy costs and harder to implement ideas when a fund is co-managed (Ferreira et al., 2013, p. 505). This study has given us inspiration on the research method to calculate alpha by using the Carhart Four Factor Model.
Cremers et al. (2016, p. 540) conducted a study which included indexing and active funds across 32 countries. The study investigated the determinants of performance of active funds. The regression model conducted by country of sale concluded a negative relationship of size and performance (Cremers et al., 2016, p. 558). Further, fund age and performance showed a positive relationship in relation to fund performance (Cremers et al., 2016, p. 558). This study is interesting to include since age showed opposite results compared to previous research above. Therefore, it will be interesting to further investigate the age variable in relation to fund performance for the Swedish fund market.
A study made by Cuthbertson et al. (2016) investigated the mutual fund performance in relation to management effect. Manager characteristics were investigated in the study and one variable was gender. The study concluded there was no relation between gender and mutual fund performance (Cuthbertson et al., 2016, p. 172). Moreover, size and age had a negative relationship to fund performance (Cuthbertson et al., 2016, p. 167). This study has given us the inspiration to include gender as a variable.
2.2 Summary of previous research
Where no conclusion is an included variable which showed no significance, negative is a negative effect of the variable on alpha, positive is a positive effect of the variable on
alpha. Parentheses show the region where the effect is shown on fund performance.
Since most of the studies showed a negative effect of size on performance it indicates this variable can be taken into consideration. Further, previous research suggested Total Expense Ratio to be important to examine the determinants of risk-adjusted performance of equity funds. Thus, this challenges the efficient market hypothesis (EMH), and abnormal return can be achieved by selecting funds based on their characteristics.
Moreover, other variables seem to vary in conclusion. Therefore, these variables are interesting to further investigate whether they have a relationship with fund performance in Sweden 2003-2019.
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3. Theoretical framework
In this chapter the concepts to the chosen area will be presented which will give a deeper understanding of the chosen area to determine which variables affect mutual equity fund performance. Furthermore, theories in finance will be presented which are relevant to our thesis topic. The theories that will be included are Modern Portfolio Theory, Diversification effect, CAPM, Fama French Three Factor Model, Momentum effect, Carhart Four Factor Model, Efficient Market Hypothesis and Joint Hypothesis (Problem). These theories will be explained and the reason why the theories are relevant to our study. Moreover, there will be a critical standpoint to the chosen theories.
3.1 Mutual funds
There are four types of mutual funds: open-end funds, closed-end funds, exchange-traded funds, and unit investment trusts (Elton & Gruber, 2013, p. 1012). However, typically open-end funds are considered mutual funds and are the largest (Elton & Gruber, 2013, p. 1012). Open-end mutual funds, from now on only called mutual funds, are investment companies which pool money from many investors and invest in different types of securities (Bodie et al. 2011, p. 96). They are priced daily based on the net asset value (NAV) (Bodie et al., 2011, p. 96), but can be traded any time of the day (Elton & Gruber, 2013, p. 1014). Mutual funds often specialize in one category of the security market (Baker et al., 2016, p. 3). Such categories can for example be high-yield bonds, mid-cap stocks or large-cap growth stocks (Baker et al., 2016, p. 3). There are costs to investing in mutual funds, named fees and expenses (Baker et al., 2016, p. 3). According to Baker et al. (2016, p. 3) there are five types of costs which are distribution charges, management fees, other fund expenses, shareholder transaction fees, and securities transaction fees.
Throughout this study, these will only be named expenses.
3.1.1 Mutual equity funds
Mutual equity funds mostly invest in stocks (Bodie et al., 2011, p. 97). However, mutual equity funds can also include fixed income or other income securities (Bodie et al., 2011, p. 97). This study will only include mutual equity funds. Equity funds are one of the major financial assets (Phalippou & Gottschalg, 2009, p. 1747).
3.1.2 Index funds
An index fund is a fund which aims to match their performance to a specific market index (Bodie et al., 2011, p. 98). This is made by investing in companies on, for example, OMX Stockholm 30, or another index (Bodie et al., 2011, p. 98). To replicate the index the weights of stocks in the fund need to be the same as the index (Baker et al., 2016, p. 4).
However, some index funds use derivatives and securities to mimic the index, named synthetic trackers (Baker et al., 2016, p. 4). Typically, index funds are cheaper to invest in since they engage in less trading (Baker et al., 2016, p. 4). Several studies have found that these have performed better than actively managed funds (Jensen, 1968, p. 415;
Gruber, 1996, p. 783). This is an interesting perspective of the study and since several studies have concluded that index funds perform better, then we will continue to examine whether active managed or index funds perform better on the Swedish fund market.
3.1.3 Actively managed funds
Equity funds, sector funds and global funds are often actively managed funds (Bodie et al., 2011, p. 98). These funds consist of a manager who evaluates and selects assets to
incorporate in the fund and therefore, these funds usually have a larger fee than index funds to compensate the manager (Bodie et al., 2011, p. 98). The purpose of the funds is to outperform the market (Bodie et al., 2011, p. 106). Actively managed funds can have one or more managers. Gruber (1996, p. 783) mentioned the increased popularity to invest in actively managed funds even though, over time, performance of actively managed funds has been worse than indexed funds. A difference between index fund and actively managed fund is the professional management which is included in the actively managed funds (Gruber, 1996, p. 785). However, the success of professional management can be discussed, and it differs from fund to fund (Gruber, 1996, p. 785). This means the fee needs to be taken into account since good management will raise the fee and thus an effect of higher performance of the fund (Gruber, 1996, p. 785). In conclusion, actively managed funds add value to the mutual fund industry (Gruber, 1996, p. 789). However, whether investing in actively managed funds is the most beneficial strategy depends on the expected return of index funds (Gruber, 1996, p. 804).
3.1.4 Return
In the investment environment, higher returns can be achieved if greater risk is applied (Bodie et al., 2014, p. 1). Risk-return trade off the securities markets, this means assets with higher risk should offer a higher expected return compared to lower-risk assets (Bodie et al., 2014, p. 10). This risk-return tradeoff is related to the Markowitz model, which assesses the relation that a riskier investment will lead to a greater potential return (Mangram, 2013, p. 62). Abnormal return shows the differences between the security’s actual return and expected return (Bodie et al., 2014, p. 353). The equity premium is central in determining the risk premium in CAPM (capital asset pricing model) (Martin, 2017, p. 367). The determination of expected return is linked to asset prices (Martin, 2017, p. 368). Recent research showed that there is a high correlation between investors expectations and past returns (Greenwood & Shleifer, 2014, p. 728). On the other hand, another study by Arnott and Bernstein (2019, p. 80) concluded that investors could not rely on historical stock returns when looking at future returns. Most investors believe the return equity risk premium to be higher than what it really is (Arnott & Bernstein, 2019, p. 81). Further, return can be measured as risk-adjusted return to be comparable with assets of different risks (Bodie et al., 2011, p. 821).
3.2 Theories in Finance
Below we will present theories in finance. The presented theories will be the Modern Portfolio Theory, diversification effect, Capital Asset Pricing Model, Fama-French Three Factor Model, momentum effect, Carhart’s Four Factor Model, Efficient Market Hypothesis and Joint Hypothesis (Problem).
3.2.1 Modern Portfolio Theory
Modern Portfolio Theory (MPT) was first introduced by Nobel prize winner Harry Markowitz in 1952 (Mangram, 2013, p. 59). Markowitz (1952, p. 77) describes the difficulty of choosing a portfolio. The Modern Portfolio Theory implies that an investor can minimize the risk of the portfolio by diversification, and that for any level of risk an investor will choose the portfolio with the highest return (Markowitz, 1952, p. 77).
However, Markowitz (1952, p. 79) argued that not all risk can be eliminated by diversification. The MPT can be applied to mutual funds, since the mutual funds are composed of many stocks and other financial instruments to get the best return for a specific risk level. The MPT includes several assumptions. One assumption in the Modern Portfolio Theory is that investors are risk averse (Beyhaghi & Hawley, 2013, p. 22). This
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means that an investor prefers the investment with the lower risk with the same return (Beyhaghi & Hawley, 2013, p. 22). Ian Shipway (2009, p. 69) explained the Modern Portfolio Theory was founded since investors began to collect several investments into a portfolio instead of holding only one investment. Shipway (2009, p. 69) also concluded that if an investor aims for higher returns, higher risk is required.
However, the MPT has been criticized. Levy and Levy (2014, p. 372) criticised the portfolio optimization, because of statistical errors in the assumption on Markowitz model mean variance. This leads to parameters that result in errors will not be a successful assumption mean variance (Levy & Levy, 2014, p. 372). The assumption of mean variance addresses that investors know the expected return, variances and covariance, whereas in reality this is not the case (Levy & Levy, 2014, p. 372). Further, a critique towards MPT is that the underlying assumptions of financial markets due to the model cannot to a great extent be applied to the real world (Mangram, 2013, p. 67). Wilford (2012) has criticised the MPT. Wilford (2012, p. 93) argued that the modern portfolio itself fails to achieve the assumptions underlying the modern portfolio theory, which leads to miscalculations. Further, a critique is due to lack of knowledge of the basic assumptions which shows the modern portfolio is not an effective way to choose a portfolio (Wilford, 2012, p. 101). Moreover, no taxes or transaction costs are taken into account in MPT which exists in the real world which may affect the optimal portfolio selection (Mangram, 2013, p. 67). The MPT theory is included in our thesis since it tells us an investor should optimize their portfolio. We assume all funds have the same risk, based on this we can see which variables give abnormal returns. Since MPT also addressed the diversification effect a geographical focus will be included in our study which we aim to examine whether it has an impact, and investors earn abnormal returns by diversification thus limit the risk.
3.2.2 Diversification effect
The theory of diversification describes the action by an investor to include more assets in the portfolio (Bodie et al., 2011, p. 197). This means that when investors apply diversification in their portfolio it can eliminate the risk of the portfolio (Bodie et al., 2011, p. 197). However, to reduce the entire risk is almost impossible even if an investor includes a high number of assets and this can be explained by the macroeconomic factors that will still affect the securities (Bodie et al., 2011, p. 197). In the Markowitz model diversification is explained by the by “the relationship between correlations and portfolio risk” (Mangram, 2013, p. 66) Diversification can also be named as non-systematic risk, and the risk left from diversification is named market risk (Bodie et al., 2011, p. 197).
Criticism has been presented to the diversification effect due it can be argued that it cannot eliminate all the risk (Mangram, 2013, p. 66). This means that no amount of diversification has the possibility to eliminate systematic risk, which is a risk that can be seen to affect companies and countries at the same time (Mangram, 2013, p. 66).
This theory is interesting to incorporate into our study since the diversification effect states that it is good to invest in a diversified portfolio. As mentioned above, since we aim for an international view by including a geographical focus.
3.2.3 Capital Asset Pricing Model and Jensen’s alpha
The Capital Asset Pricing Model (CAPM) predicts the expected return on risky assets (Bodie et al., 2011, p. 280). The model builds on the market rate, risk-free rate, and a beta coefficient. (Bodie et al., 2011, p. 282). When the variables are presented a calculation of
the expected return can be done for a specific stock. If the actual return of a portfolio is deviating from expectations, the ‘excess return’ is denoted by Jensen’s alpha and is calculated using the equation:
!! = #!− [#"+ '!(## − #")]
Equation 1, Capital Asset Pricing Model (Bodie et al., 2011, p. 822).
Depending on the change in beta it will show different expected returns for the asset (Bodie et al., 2011, p. 290). The problem with CAPM is however the restriction of linearity, as expected return is only a function of an asset’s systematic risk (Harvey, 1989, p. 289). Thus, the model cannot capture the dynamics of assets (Harvey, 1989, p. 315).
3.2.4 Fama French Three Factor Model
Fama and French (1993) developed a new model for risk factors in stock and bond returns and it stems from critique of CAPM where they see that beta is not an ideal risk factor (Fama & French, 1993, p. 3). The model they developed also includes a variable of size (SMB, small minus big) and a variable of book to market (HML, high minus low) (Fama
& French, 1996, p. 55). The model is as follows:
+$ − +"= !$+ ,$(+%− +") + -$./0 + ℎ$2/3
Equation 2, Fama-French Three Factor Model (Fama & French, 1996, p. 56) Although the model is better at explaining asset pricing than CAPM it still has some limitations. One criticism for the model is the methodology behind it (Foye et al., 2013, p. 5). Berk (1995) is one who has criticized the model. The findings showed that size should not be regarded as a pricing anomaly (Berk, 1995, p. 285). However, the study showed that market value is important to regard (Berk, 1995, p. 285) and thus the HML variable is important.
3.2.5 Momentum effect
Jegadeesh and Titman (1993) found that stocks which historically have high returns are more likely to perform well in the future and vice versa. This has come to be known as the momentum effect. The effect is that investors tend to overreact to information. If a stock price falls, more investors are likely to sell leading to further price decreases (Jegadeesh & Titman, 1993, p. 89). Further, a momentum portfolio or strategy is to combine these stocks into portfolios to get a higher return which can be applied to mutual equity funds since they, by definition, are portfolios of stocks (Jegadeesh & Titman, 1993, p. 89). Jegadeesh and Titman (1993, p. 89) have found that these strategies do not stem from their systematic risk or delayed reactions. The momentum effect has been criticised by Novy-Marx (2012, p. 430), it can be argued that a momentum strategy’s profitability is derived by total past performance and not the recent past performance (Novy-Marx, 2012, p. 451). The findings showed that momentum effects do not describe the return of stocks (Novy-Marx, 2012, p. 451).
3.2.6 Carhart Four Factor Model
The Carhart Four Factor Model is an extension of the Fama-French Three Factor Model and includes a variable of the momentum effect (Carhart, 1997, p. 61). It was developed by Carhart in 1997 as a description of the persistence of mutual fund performance (Carhart, 1997, p. 57). Carhart (1997, p. 57) argued that great stock picking is not what
