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Estimating the Dynamics of Mutual Fund Alphas and Betas

By Matthew Spiegel, Harry Mamaysky and Hong Zhang

Abstract

Consider an economy in which the underlying security returns follow a linear factor model with constant coeffcients. While portfolios that invest in these securities willin general, have a linear factor structure, it will be one with time-varying coeffcients. However, under certain assumptions regarding the portfolio's investment strategy, it is possible to estimate these time-varying alphas and betas. Importantly, this can be done without direct knowledge of either the portfolio manager's exact investment strategy or of the alphas and betas of the individual securities in which the portfolio invests. This paper develops and estimates a Kalman ?lter statistical model to track time-varying fund alphas and betas. Several tests indicate that relative to a rolling OLS model the Kalman ?lter model produces more accurate fund factor loadings both in and out of sample. This appears to be in large part due to the attempts of fund managers to time the market by varying their fund's risk exposure from period to period. Another advantage of the Kalman ?lter model is that the dynamic parameter estimates can be used to classify funds by their trading strategies and to determine the s

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