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The Relation Between Idiosyncratic Volatility and Returns for U.S. Mutual Funds

Skogström Lundgren, Kevin LU (2016) NEKP03 20152
Department of Economics
Abstract
Theoretically the relation between returns and idiosyncratic volatility should be non-existent or positive. Many empirical studies confirm this but Ang, Hodrick, Xing and Zhang (2006) contest the conventional view and find a negative relationship for a sample of U.S. firms. I contribute to the field by investigating the relation for a sample of U.S. mutual funds. The sample consist of a total of 10 917 equity mutual funds, the funds are divided in to four different classes depending on equity focus (growth, value, small cap and large cap). Data were collected for the period 1995 to 2015. Ang et al. (2006) relate returns with lagged idiosyncratic volatility making the implicit assumption that idiosyncratic volatility can be described as a... (More)
Theoretically the relation between returns and idiosyncratic volatility should be non-existent or positive. Many empirical studies confirm this but Ang, Hodrick, Xing and Zhang (2006) contest the conventional view and find a negative relationship for a sample of U.S. firms. I contribute to the field by investigating the relation for a sample of U.S. mutual funds. The sample consist of a total of 10 917 equity mutual funds, the funds are divided in to four different classes depending on equity focus (growth, value, small cap and large cap). Data were collected for the period 1995 to 2015. Ang et al. (2006) relate returns with lagged idiosyncratic volatility making the implicit assumption that idiosyncratic volatility can be described as a random walk. But as Fu (2009) I find that this is not true and use an AR(2) model to estimate idiosyncratic volatility, inspired by Chua, Choong Tze, Jeremy Goh, and Zhe Zhang (2010). The idiosyncratic volatility is estimated relative to the Carhart (1997) four- factor mode and divided in to an expected and unexpected part as in Chua et al. The relation is examined using Fama-MacBeth (1973) regressions with both gross return and the Carhart alpha as dependent variables. The results suggest a positive relation only when using the Carhart alpha as dependent variable and all the control variables. Otherwise the results are inconclusive. As an additional robustness test I perform portfolio sorting on EIV without control variables and get results that suggest a negative relation. (Less)
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author
Skogström Lundgren, Kevin LU
supervisor
organization
course
NEKP03 20152
year
type
H2 - Master's Degree (Two Years)
subject
keywords
Idiosyncratic volatility, Mutual funds, Carhart four-factor model, ARIMA model, Carhart four-factor alpha
language
English
id
8522263
date added to LUP
2016-02-11 14:38:39
date last changed
2016-02-11 14:38:39
@misc{8522263,
  abstract     = {Theoretically the relation between returns and idiosyncratic volatility should be non-existent or positive. Many empirical studies confirm this but Ang, Hodrick, Xing and Zhang (2006) contest the conventional view and find a negative relationship for a sample of U.S. firms. I contribute to the field by investigating the relation for a sample of U.S. mutual funds. The sample consist of a total of 10 917 equity mutual funds, the funds are divided in to four different classes depending on equity focus (growth, value, small cap and large cap). Data were collected for the period 1995 to 2015. Ang et al. (2006) relate returns with lagged idiosyncratic volatility making the implicit assumption that idiosyncratic volatility can be described as a random walk. But as Fu (2009) I find that this is not true and use an AR(2) model to estimate idiosyncratic volatility, inspired by Chua, Choong Tze, Jeremy Goh, and Zhe Zhang (2010). The idiosyncratic volatility is estimated relative to the Carhart (1997) four- factor mode and divided in to an expected and unexpected part as in Chua et al. The relation is examined using Fama-MacBeth (1973) regressions with both gross return and the Carhart alpha as dependent variables. The results suggest a positive relation only when using the Carhart alpha as dependent variable and all the control variables. Otherwise the results are inconclusive. As an additional robustness test I perform portfolio sorting on EIV without control variables and get results that suggest a negative relation.},
  author       = {Skogström Lundgren, Kevin},
  keyword      = {Idiosyncratic volatility,Mutual funds,Carhart four-factor model,ARIMA model,Carhart four-factor alpha},
  language     = {eng},
  note         = {Student Paper},
  title        = {The Relation Between Idiosyncratic Volatility and Returns for U.S. Mutual Funds},
  year         = {2016},
}