ACF 602/622 Coursework

Group 53

Gulcin Ergun 35000199

Nicolas Demetriou 35383660

Shihab Hasan Chowdhury 35080605

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TASK 1

For the first part, we are going to perform Fama-French 5 factor regression for each Large Value
and Small Growth Mutual funds from January 2010 to December 2019.

We are going to observe whether the Fama French 5 factor Model captures average returns on the
variables and to observe the direction of correlations between variables; Size, Value, Profitability
and Investment effects that are used for explaining asset returns;

SMB-Small minus Big- Size effect: small-capitalization firms earned higher than large-capitalized
firms; every year (in June) smallest portfolio doing % 10 better than large. In other words, if a
portfolio has a more small-cap, companies, it is expected to outperform the market in the long run.

HML-High minus Low- Value effect: Companies with a low book to market ratio refers “Low”
which are called “growth stocks” and “High” for the companies who have a high book to market
ratio also these companies refer “valued stocks”. When we compare the performance of these,
research shows that value stocks outperform that growth stocks in the long term. In other words,
value stocks’ average returns expected to be higher than growth stocks.

RMW-Robust minus Weak- Profitability effect: Profitability effect: Profitable company earns
higher returns than unprofitable.

CMA-Conservative minus Aggressive- Investment effect: Low asset growth rates earn better
returns; companies directing their profit into growth projects are more likely to lose in the stock
market.

eit: zero mean residual.

If the parameters of the factors capture all the information than ai (intercept) is zero for all
securities and portfolios.

It is important to mention; the tests done by Fama and French shows HML value effect become
redundant for describing average returns when investment and profitability added. The model
shows that the highest expected returns are obtained by companies that are small, value and

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profitable companies with no major growth prospects. The main drawback of the model is it fails
to capture low average returns on small stocks.

Question 1&2

Coding is provided with SAS.doc

Small growth: Invesco Oppenheimer Discovery Fund OPOCX

Small Growth mutual funds that consist of companies with faster growth in revenue or earnings
than their industry peers or the general market and Small market capitalization (the definition of it
changes among brokerages, however, in general, refers market cap. between 300 million $ – 2
billion $). They have above-average growth, which re-invest their earnings into the company for
enlarging, research and development and acquisitions. Most growth funds offer higher potential
capital appreciation; However, they are subject to above average risk which means in return of
high-risk investors will probably get high reward. When the market has an upward trend with the
growing economy these category funds have tremendous potential for excessive gains. As an
example, the US small growth category had fallen harder than the other categories.

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When we look at the Analysis of Variance table; our model itself significant and holds the linear
relation (F value: 29.17 p value<0.05) within the independent variables and dependent variable;
Therefore, we can proceed with our analysis.

One of the measures of Goodness of the model is R sqr. It is assumed that the higher the R sqr.
Better the fit of the model. Here R square tells that app. % 75 of variability in the dependent
variable explains by the independent variables in the model.

The pricing error “a” (intercept) shows that as being statistically insignificant (t-statistic<1.96 and
p value>0.05) that we fail to reject the null hypothesis, therefore, alpha (a) is equal to zero.

FF5 Factor model sensitivities of the MKTRF, SMB, HML, RMW are statistically significant at
% 5 level and there is a negative relation with HML and RMW which does not hold evidence.
Parameter of CMA is not statistically significant (t-stat:0.17). It could be because, FF5 factor has
a failure to explain the low average returns on a small company that invest a lot despite low
probability, which means the model has some problems in explaining the poor performance of
small growth companies.

Large Value: Principal Equity Income Fund PQIAX

A Large Value Mutual fund is a fund that follows a value investing strategy that investing in
undervalued stocks. In other words, stocks that are deemed to be cheap that they have a high book
to market ratio. Value funds are a type of long-term investing tools because they invest in slower-
growing, low priced stocks. Large value US equity funds appreciated 9.5% annual return in 5
years’ time where high yield bonds offer % 3.34 gain.

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Analysis of Variance table: model statistics shows that our model itself significant and holds the
linear relation (t-stat: 116.09, p value<0.05) with independent variables and dependent variable;
Therefore, we can proceed with our analysis.

The goodness of the fit of our model is satisfactory according to R sqr. It is assumed that the higher
the R sqr. Better the fit of the model. %93 of the variability in returns explained by the independent
variables which are very high.

The intercept of the model is statistically insignificant (p value>0.05) that we fail to reject the null
hypothesis and alpha is equal to zero.

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FF5 Factor model sensitivities of the SMB, HML, RMW and CMA are not statistically significant
at % 5 level that they are redundant for explaining average returns. But the parameter of Excess
Return works with a high significance.

As a conclusion for large value mutual fund; our empirical test on the five-factor model does not
explain the average return of large value mutual fund.

Questions 3 & 4
As a performance indicator, we check alpha and beta and R squared. Basically, for the same level
of risk (same betas) which has higher alpha, portfolio fund manager able to generate higher returns
than benchmark.

The efficient market hypothesis (EMH) states that the prices of the securities are fully reflected by
the available information. Therefore, investors who are buying securities in an EMH should expect
to get an equilibrium rate of return. However, mispricing exists in the real world, but you cannot
have a predictable pattern that can lead to a steady outperformance. The Large value stocks
outperform the small growth stocks on the risk-adjusted basis, but for a shorter period, this is not
always the case. In a short period, the performance of both mutual funds depends on the economic
cycle of the market. The best time to invest in growth stocks is during an economic growth cycle
in the market, and for value, stocks are during recessions. Therefore, for the large value stock to
perform better than a small growth stock depends on the period were held. Moreover, for a longer
period, the value stock outperforms the growth stock but the decision where an investor should
invest in is due to investors' preference. However, in long periods if growth stock outperforms
value stock it will be a significantly large difference in the performance of growth stock. Therefore,
a value stock tends to be justified in the long run. In general value, mutual funds outperform growth
funds over the long term but can be underperformed in the short term. The EMH does not imply
that the investors cannot outperform the market because it may be some cases that an active
manager can achieve abnormal returns. Mutual Fund managers as a group that uses an active
investing strategy do not outperform the passive market indices in most cases. There are mutual
funds that beat the benchmarks but not for a long period. The main aim of active investing is to
beat the benchmark and achieve consistent performance. Moreover, before the fees the stock-
picking funds outperform and beat the index funds. However, after the fees for active management
lead to a huge decrease in performance which makes it extremely difficult to overcome. Also, most

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of the fund managers do not have access to private information needed to choose winning
investments. Therefore, most of the times the outperformance is not coming from skills but,
consequently it comes due to randomness. Passive fund investment which tracks an index over
time has a higher probability of a better performance compared to an actively managed mutual
fund for longer periods. There is no consistent way to beat the market for the long term, so, the
mutual fund managers cannot maintain an abnormal performance.

Question 5

Stambaugh and Yuan mispricing- factor model proposes two new factors- based on anomalies-
addition to size and market factors to obtain a four-factor model that construct a single composite
mispricing measure by averaging 11 anomalies. Two new factors MGMT and PERF; conceptually
MGMT contains different investment measures (Average ranking over 6 anomalies that could be
directly affected by management) and PERF(Average ranking over 5 anomalies) contains different
probability measures.

Small Growth:

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When we look at the Analysis of Variance table; our model itself significant and holds the linear
relation (t-stat: 109.41 p value<0.05) with the independent variables and dependent variable;
Therefore, we can proceed with our analysis.

R square tells that app. % 85 of variability in the dependent variable is explained by the
independent variables in the model.

The intercept of the model is statistically insignificant (p value>0.05) that we fail to reject the null
hypothesis and alpha is equal to zero.

Additionally, t-value for other 4 factors are statistically significant while describing linear relation
with the return of mutual fund; except from MGMT, others all have positive relation with returns.

Large Value:

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Our model itself significant with t-value: 298.80; Therefore, we can proceed with our analysis.

R square is %94- very high, nearly close to 1. Unlike the regression result of small growth mutual
fund, large value mutual fund regression results do not support the evidence for the four-factor
model.

As we know MGMT and PERF factors provide better estimates than FF-3, FF-5 and q-4 models;
However, these factors are not working for our mutual fund returns.

Task 2

Question 1 and 2

The first step is to take NYSE, Amex and Nasdaq stocks and classify them into three size groups
per month, after that the second step is to classify them into deciles. The Post-Earnings
announcement drift (PEAD) is when a stock continues to move in the direction of the surprise
earnings. The stock’s price tends to increase higher than the expected during earnings
announcement periods. Both Momentum and PEAD shows that investors tend to underreact to the
earnings information, and both are relatively short-lived. The efficient market theory states that
everything is priced as soon as we know the earnings but in the real world, we have the PEAD
anomaly and when we have a positive announcement the price will close higher in the future.
However, the price will gradually adjust to the new information and it will continue to be adjusting
the price to the direction of the earnings announcement. This imbalance that causes the price to
continue to rise is an opportunity, where we can buy after the good earnings announcement since

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the price will rise in the future and sell the stock in the future when the price will tend to be higher.
The strategy we will follow even after the announcement of the result, we will still buy and hold
and still make money. On the other hand, if a company announced bad results then the correct
strategy is to short the stock. We come up with a trading strategy using the PEAD which is called
Standardized unexpected earnings (SUE), which is the unexpected earnings per unit of standard
deviation. The rank ordering of PEAD is based on the score of the SUE and the momentum is
based on past returns or a measure of the earning news.

Momentum Effect:

The momentum effect can obtain superior returns by holding a long position in stocks that have
outperformed in the past and short the stocks that are underperformed in the past during the same
period. The portfolio P1 is called the losers’ portfolio and P10 is call the winners portfolio.

Analysis Variable: ewret Return

Momentum Port. N Observations Mean t Value Pr > |t|
1 306 0.0128089 2.67 0.0080
2 306 0.0095292 2.70 0.0072
3 306 0.0112691 3.78 0.0002
4 306 0.0130462 4.79 <0.0001
5 306 0.0135908 5.23 <0.0001
6 306 0.0145058 5.62 <0.0001
7 306 0.0150215 5.67 <0.0001
8 306 0.0160365 5.65 <0.0001
9 306 0.0170678 5.27 <0.0001
10 306 0.0190607 4.60 <0.0001

Table 1:Momentum Portfolio Regression

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Table 2:Regression for the three groups for Momentum portfolios.

As we can see from table 1, all the observations are 306 for each portfolio and the P1 has a mean
of 0.0128089 which is lower than the winner portfolio of 0.0190607. The t value for P1 is 2.67
and the t-value of P10 is much higher to 4.60 which is sufficiently large. The probability of
obtaining a t-value with 306 observations is 0.0080 for P1 and <0.0001 for P10. The correct
strategy for these equally weighted portfolios as we can see from table 2 is split the stocks into 3
size groups. Therefore, we should sell the portfolio P1 and buy the portfolio P10 which is the
winner’s portfolio. The resulting buy and sell which is the difference between portfolios P10 and
P1 is that we have an excess mean of 0.0062519 with a t-value of 2.04 and the probability of
getting this t-value of 0.0421. We can sufficiently conclude that momentum portfolio P10
outperforms P1 as we can see from table 2.

Post-Earnings Announcement drift (PEAD):

We scale the SUE to come up with conclusions, you cannot just take the difference. Standard
deviation is important to see by how much the mean deviate from the expected number. Companies
with high volatility they expect to produce high earnings, but it does not mean that it performs
better than a stable volatile company. To account the variability in our strategy we must by
considering the standard deviation so, to get the SUE we subtract the actual earning minus the
expected earnings, and we divide by the standard deviation. We then rank the portfolios based on
the SUE and we get the summary statistics.

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 Analysis Variable: EWRET
Rank for N Observations Mean t Value Std Dev Pr > |t|
Variable SUE
1 325 0.7220096 2.23 5.8468295 0.0267
2 326 0.6490689 2.26 5.1808311 0.0244
3 333 0.5263153 1.74 5.5082435 0.0821
4 329 0.7624134 2.76 5.0058489 0.0061
5 326 1.1756929 3.89 5.4614426 0.0001
6 331 1.1068595 3.97 5.0738798 <0.0001
7 334 1.0645893 4.02 4.8360080 <0.0001
8 325 0.8714323 3.23 4.8694884 0.0014
9 329 1.0293769 3.70 5.0519586 0.0003
10 325 1.1906312 4.20 5.1133841 <0.0001
Table 3:PEAD Decile portfolio regression

Analysis Variable: HL
N Observations Mean t Value Std Dev Pr > |t|
325 0.4686217 2.05 4.1223332 0.0412
Table 4:PEAD High performing minus Low Performing portfolio statistics

Table 3 shows the PEAD decile based on SUE ranking. The higher the SUE(P10) the better as we
can see from table 3. For P1 we have a mean of 0.7220096 with a t-value of 2.23 and a standard
deviation of 5.8468295 and a probability value of 0.0267. On the other hand, for P10 we have a
higher mean of 1.1906312 with a t-value of 4.20 and a lower standard deviation of 5.1133841. The
spread (P10-P1) between P1 and P10 is shown in table 4 and we have an excess mean of 0.4686217
with a t-value of 2.05 a standard deviation of the mean of 4.1223332 with a probability that we
will get this t-value of 0.0412. The earnings for P10 is less volatile than P1 as we can see the
standard deviation for both from table 3 and the highest mean is for the portfolio P10. Therefore,
the better strategy is to go long on the top decile with the highest score (SUE) and go short on the
bottom decile with the lowest SUE.

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References:

Carhart, M. (1997). On Persistence in Mutual Fund Returns. Journal of Finance, 52 (1),. 1 57–82.

Cremers, M., & Antti P. (2009). How Active Is Your Fund Manager? A New Measure That
Predicts Performance. Review of Financial Studies, 22 (9), p.3329–3365.

Chan, L., Jegadeesh, N., & Lakonishok, J. (1996). Momentum Strategies. Journal of
Finance, 51(5), 1681-1713.

Daniel, H. & Sun (2019) Short and long-horizon behavioral factors. Review of Financial Studies,
forthcoming.

Fama, E., & French, K. (2015). A five-factor asset pricing model. Journal of Financial
Economics, 116(1), 1-22.

Jegadeesh, N., Sheridan, T. (1993). Return to buying winners and selling losers: Implications for
stock market efficiency. Journal of Finance, 48, p. 65–91.

Petajisto, A. (2013). Active share and mutual fund performance. Financial Analysts Journal, 69(4),
73-93.

Stambaugh, Robert F. and Yuan, Yu, Mispricing Factors (September 2015). NBER Working Paper
No. w21533.

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