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Jensen alpha and market climate

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Abstract

This article studies the impact of market climate on the classic Jensen alpha (JA) of equity funds. We show analytically that the one-factor JA of a fund consists of (i) the fund’s alpha based on the assumed multi-factor model driving fund returns and (ii) further components that are subject to time-dependent market phases of factor realizations. In our empirical study, we analyze JAs and respective fund rankings for a survivorship bias-free data set of 3102 US equity mutual funds. Our results show that factor realizations during the specific lifetime of a fund clearly affect its JA and rank position. This impact of factor realizations is particularly strong for funds with shorter lifetimes. To quantify the market climate impact, we compare classic JAs of funds with their time period-adjusted JAs, removing the influences of market phases. Finally, our main results are robust when applying alternative multi-factor models as return generating process of funds.

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Notes

  1. Alternatively, even longer time periods could be considered to estimate ‘normal’ factor alphas that contain no market climate impact (compare, for example, Pastor and Stambaugh, 2002a; Krimm et al, 2012). Next to this time-period adjustment of the JA, it is possible to take advantage of an improvement in the significance of measured alpha which results from a joint estimation of the four-factor model in a Bayesian framework (Stambaugh, 1997; Pastor and Stambaugh, 2002b). We thank an anonymous reviewer for this suggestion.

  2. We choose funds with the following Lipper objective codes: Capital appreciation funds (CA), equity income funds (EI), growth funds (G), growth and income funds (GI), mid-cap funds (MC), and small-cap funds (SG). For fund selection, we rely on the most recent objective code.

  3. Since each fund has at least 36 months of monthly returns, no funds disappeared in the first 3 years and no new funds started after January 2007.

  4. The monthly factor and T-bill returns are downloadable from Kenneth French’s Website (mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html), which also contains information about the factor construction.

  5. We use Newey and West (1987) corrected standard errors that account for heteroskedasticity and autocorrelation when testing the significance of the coefficients.

  6. Monthly returns of the liquidity factor are downloadable from Lubos Pastor’s Website (faculty.chicagobooth.edu/lubos.pastor/research/). Monthly returns of the BAB factor and the QMJ factor can be downloaded from Andrea Frazzini’s Website (www.econ.yale.edu/~af227/data_library.htm). Both Websites also contain information about the respective factor construction.

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Acknowledgements

The authors are grateful to participants of the CFR Research Seminar of the University of Cologne 2008; the SWFA Annual Meeting 2008, Houston; the EFA Annual Meeting 2008, St Pete Beach; the 2008 FMA Annual Meeting, Dallas; the Annual Meeting of the German Finance Association 2008, Münster; the Annual Meeting of the German Academic Association for Business Research 2009, Nürnberg; the Southern Finance Association Annual Meeting 2009, Captiva Island; and, especially to Oliver Entrop, Alexander Kempf, Peter Lückoff, Oliver Schnusenberg, John Stowe, Marco Wilkens and Wenjuan Xie for helpful comments and suggestions on earlier drafts of this paper previously titled ‘Ranking of equity mutual funds: The bias in using survivorship bias-free datasets’. Views expressed in the article are the authors’ own and do not necessarily reflect those of Robeco. We are responsible for any remaining errors.

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  1. Friedrich-Alexander-Universität (FAU) Erlangen-Nürnberg, Chair of Finance and Banking, Lange Gasse 20, Nürnberg, 90403, Germany

    Hendrik Scholz

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  1. Bernhard Breloer
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  2. Hannah Lea Hühn
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  3. Hendrik Scholz
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Breloer, B., Lea Hühn, H. & Scholz, H. Jensen alpha and market climate. J Asset Manag 17, 195–214 (2016). https://doi.org/10.1057/jam.2016.4

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