Common Factors in Mutual Fund Returns

Abstract

A great deal of the literature in financial economics contains the assumption that returns are a linear function of a set of observable factors. The specification of the variables in the linear process (known as the return-generating process) is one of the key issues in finance today. The return-generating process is an important building block in asset pricing models, portfolio optimization models, mutual fund evaluation, and event studies. For many purposes (such as in developing asset pricing models and evaluationg mutual fund performance), it is important to separate systematic from non-systematic factors. There have been numerous attempts to examine the number and type of systematic factors in equity returns. The purpose of this study is to determine the systematic factors by examining mutual fund returns. One important implication of modern portfolio theory is that, given a belief about systematic factors, an investor should select an exposure (beta) to each factor, a level of expected risk-adjusted return (alpha) and a level of residual risk (residual variance). The mutual fund industry has an incentive to offer an array of exposures to systematic factors in order to meet investors' differing objective functions. Therefore, mutual funds provide a logical way to obtain portfolios which have spread on the characteristics of interest while smothering much of the noise inherent when a model is fitted to individual security returns.