Investment and profitability factors in mutual fund performance evaluation: a conditional approach

ABSTRACT

This paper provides new evidence on the appropriateness of the Fama-French five-factor model to evaluate international equity funds’ performance. After extending this model to a conditional framework by allowing for time-varying risk and performance, the results show that funds underperformed during the 2000–2017 period. Funds investing globally and in Europe tend to invest in aggressive firms, but only the latter are exposed to firms with weak profitability. We thus conclude that although both investment and profitability factors are significant in explaining fund returns, the investment factor plays a more relevant role irrespective of the funds’ geographical area of investment.

KEYWORDS:

• Mutual fund performance
• factor models
• conditional models
• profitability
• investment
• international funds

JEL CLASSIFICATION:

• G11
• G12
• G15

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ Gregoriou, Racicot, and Théoret (2016) test an unconditional version of the Fama and French (2015) five-factor model in a hedge fund setting and find that this type of funds seems to prefer stocks of firms with lower exposures to the investment and profitability factors.

² As an additional robustness test, since the model remains unable to explain the momentum premium, we have also estimated a conditional 6-factor variant by adding the momentum factor to the model. However, the results obtained were very similar and are not reported here for the sake of brevity. Nevertheless, they are available upon request from the authors.

³ Available at http://web3.cmvm.pt/english/sdi/fundos/app/index.cfm.

⁴ We note that the time series excess returns of both portfolios exhibit statistically significant (at 5% level) negative skewness and positive excess kurtosis, which leads to the rejection of the normality hypothesis. As pointed out by Adcock et al. (2012), the non-normality of fund excess returns further supports the use of conditional rather than unconditional performance evaluation models.

⁵ However, estimating the model without the time-varying alpha term could lead to biases in conditional betas, as shown by Ferson, Sarkissian, and Simin (2008). Additionally, compared to the (unreported) unconditional model, the conditional version presents a higher explanatory power.

⁶ This evidence is further reinforced at the individual fund level, with only 34% of the Global funds presenting a statistically significant exposure, at the 5% level, to the HML factor.

⁷ It should be noted that 50% of the European funds present a statistically significant exposure (at the 5% level) to the HML factor.

⁸ In fact, for European funds, we find a positive correlation between HML and CMA (0.69) and a negative correlation between HML and RMW (−0.40). For Global funds, correlations are not only higher but both positive (0.81 and 0.44, respectively).

Additional information

Funding

This work was supported by the Fundação para a Ciência e a Tecnologia [UID/ECO/03182/2019,UID/GES/04752/2019].