Benchmark and Alternative Models

Benchmarks used in this analysis include Sharpe (1964)-Lintners (1965) CAPM and
Fama and Frenchs (1993) 3-factor models. The former uses market portfolios
excess returns as a proxy for explaining returns, whereas the latter further employs
value and size for explaining the variation in returns. Three other models that have
been utilized include Carharts (1997), as well as Pastor-Stambaughs (2003) 4factor models, and a 5-factor model in which all the factors have been included in the
regression. These models are as follows:
: 1 = + +

3 : = + + + +

4 (): = + + + + +

4 (): = + + + + +

5 : = + + + + + +

Regression Analysis

As shown in table 1, the regression coefficients have been tested at 1%, 5% and 10%
significance levels. Coefficients marked with two asterisks are significantly different
from zero at 1%, whilst the rest of the coefficients are not statistically significant at
any of the aforementioned levels; however, before making any conclusions it is
important to make sure that the least squares assumptions are satisfied and that the
regressions are unbiased and efficient.
Figure 1 shows CAPM models scatterplot of the regressor against the regrassand.
The data does not appear to follow a non-linear relationship.
1

This is return of the mutual fund in excess of the 1-month T-Bill.

The assumptions that require testing are the small-sample properties of the OLS. For
instance, the approximate normality of the error terms is assumed due to the law of
large numbers. An example (figure 3) is the approximate normality of the error terms
in the 3-factor model, which has skewness close to zero and a kurtosis of almost 3.
The exogeneity assumption is tested using the Hausman test; however, this test is
out of the scope of this assignment and the exogeneity assumption is simply
assumed to hold.
The OLS remains unbiased even if the error terms are heteroskedastic; however,
standard errors may be biased and the significant tests may be misleading. Before
testing for heteroskedasticity, it is crucial to assess whether perfect correlation exists
among the variables. Violation of this assumption may lead to Type I error2 when
conducting the White test for heteroskedsticity. Table 2 suggests that no perfect
multicollinearity exists and the White test can be conducted without any concerns for
Type I error.
The p-values of the White test for all five regressions in table 3 indicate that the null
hypothesis of homoscedasticity cannot be rejected at 10% significance level; hence,
the error terms of all regressions are homoscedastic.
Finally, to make sure that the hypothesis tests carried out are accurate, it is
important that the error terms are not serially correlated. In other words:
( , 1 ) = 0

The data in this analysis are of time-series nature; hence, it would not be surprising if
the error terms are serially correlated. This would violate the no autocorrelation
assumption and lead to inefficient estimations.
The Durbin-Watson test is employed to test for autocorrelation. This test is based on
AR(1) of the error terms. In other words:
= 1 +

|| < 1

In this case we suspect that the error terms are first order serially correlated; hence,
the use of DW test suffices.
2

Rejection of the null hypothesis (i.e. error terms are homoscedastic) even if the error terms are
indeed homoscedastic.

Results (table 4) indicate that the null hypothesis of no autocorrelation cannot be

rejected at 5% level of significance and the error terms are not auto-correlated.

Model Specification

The F-statistics in table 1 indicate that the regression models are overall statistically
significant. Furthermore, adding variables with possible explanatory power to the
CAPM model has reduced the standard errors of the regressions whilst increasing
the adjusted R-squared.
According to the literature in asset pricing, size and value, along with excess market
return explain some variation in returns. Adding size and value estimators reduced
the standard errors of the regressions and improved the models explanatory power.
However, empirical results on liquidity and momentum vary. To assess whether
momentum and liquidity in the rest of the regressions are significant, three sets of
restricted/unrestricted regressions are run. These regressions are shown for the first
set:
: = + + + + +
: = + + + +

The homoscedastic-only F-statistic is calculated as follows:

=

2
2
(

)/
2
(1 )/( 1)

It can be concluded that Carharts momentum factor is insignificant, whereas

Stambaughs liquidity factor is highly significant. The proposed 5-factor model is
significant with respect to both momentum and liquidity factors; however, given that
the F-statistic is almost half that of Stambaughs 4-factor model, the momentum
factor (which was deemed insignificant in Carharts model) is insignificant for the 5factor model. Hence, Stambaughs model is used as a proxy for measuring the
returns of the mutual funds.

Comparison of the Performances of the Mutual Funds

The 4-factor regressions are run on both mutual funds (Table 6). The regression on
the second fund is statistically significant at 1%3 and has less explanatory power with
a higher standard error. The intercept of both funds are statistically insignificant,
which implies that neither fund is capable of generating abnormal returns. Both funds
are most sensitive to the excess market return factor, though fund 1 appears to be
more sensitive to it. For instance, keeping all other variables constant, a 1% increase
in ExRm leads to 4.146% increase in excess return of mutual fund 1. The smallest
effect on both funds comes from the value factor, which has the smallest coefficients
and is statistically insignificant for both funds. All coefficients are positive for both
models, which means the dependent and independent variables are positively
related. Finally, given fund 1s larger coefficients, it is more sensitive to different
factors.
Table 7 indicates that both the mean and the median of fund 1s excess returns are
higher than fund 2. In other words, it appears that fund 1 generates higher excess
returns. To assess whether this is actually the case and the mean returns of the two
funds are not equal, the following hypothesis has been tested:
0 : 1 2 = 0
=

1 2
2
1
1

= 0.87 < |1.96|

22
2

The result indicates that the null hypothesis cannot be rejected at 5% significance
level and the mean returns are not statistically different.

Tested and adjusted for LS assumptions.

Tables and Figures

Figure 1 - Scatter Plot of the Dependent and Independent CAPM Variables

Figure 2 - Error Term Normality Test

Bibliography
Carhart, M. M., 1997. On Persistence in Mutual Fund Performance. Journal of Finance, 52(1).
Fama, E. F. & French, K. R., 1992. The Cross-Section of Expected Stock Returns. Journal of Finance,
47(2).
Fama, E. F. & French, K. R., 1993. Common Risk Factors in the Returns on Stocks and Bonds. Journal
of Financial Economics, 33(1), pp. 3-56.
Lubos, P. & Stambaugh, R. F., n.d. Liquidity Risk and Expected Stock Returns. Journal of Political
Economy, 111(3).