Idiosyncratic Risk And Mutual Fund Performance

The pricing role of idiosyncratic risk has been re-examined in the stock market in recent papers such as Ruan,Sun,and Xu(2016),and Herskovic,Kelly,Lustig,and Nieuwerburgh(2016).The results suggest that idiosyncratic risk may contain some systematic risk component,which affects the prices of all assets in the market.I postulate that the risk-adjusted mutual fund performance(i.e.,the alpha measure)should be re-evaluated by incorporating the pricing ability of idiosyncratic risk,in addition to those of the conventional systematic risk factors.I find that the alpha measures of individual funds or various portfolios of funds become more negative when the benchmark pricing model includes aggregate measures of idiosyncratic risk.In particular,if the dual-predictor noise reduction approach by Ruan,Sun,and Xu(2016)is adopted to reduce the non-priced noise in idiosyncratic risk,I find substantial further deterioration in the alpha measure.The cross-sectional distribution of p values from an F-test of the null hypothesis that idiosyncratic risk does not matter for mutual fund performance indicates that,about 25 percent of the p values are less than the conventional size of 5 percent under the null hypothesis,suggesting that there is a systematic shift in the performance measure once idiosyncratic risk is taken into account and thus confirming the pricing role of idiosyncratic risk in mutual funds.Equivalently,the cross-sectional distribution of funds'alphas t-statistics shows that the pricing model incorporating idiosyncratic risk yields more significantly negative alphas than the traditional model.Finally,I find that funds' volatility and funds' characteristics cannot predict fund performance.