The Interaction of Market Risk and Idiosyncratic Risk on Equity Mutual Fund Returns

Abstract

This study examines the importance of idiosyncratic and systematic risks in explaining equity fund returns in Malaysia. The level of market and idiosyncratic risk in a mutual fund depends on what asset class it invests in. Equity type asset classes are exposed to both systematic and idiosyncratic risk but research generally suggest that only systematic risk is relevant in mutual fund selection since idiosyncratic risk can be reduced through fund diversification. This study attempts to expand the insights of the risk-return relationship by providing additional evidence on the direct and indirect effects of investment risk on equity mutual fund returns. Employing partial least squares structural equation modelling (PLS-SEM), we also explore if idiosyncratic risk moderates the relationship between market risk and mutual fund returns. A sample of 150 Malaysian domestic equity mutual funds comprising of large, mid & small-cap equity funds were selected from the Morningstar website.  The results indicate that market risk does not influence mutual funds returns but idiosyncratic risk has a significant and positive effect. Idiosyncratic risk is proxied by fund characteristics comprising of size, age, expenses and fund manager ability. This study shows that fund size, age or expenses are not significant and only the fund alpha which measures fund manager ability is relevant in predicting fund returns. The study also finds that the fund alpha moderates the influence of market risk on returns by changing the nature of the relationship from positive to negative.