Why is Timing Perverse?
30 Pages Posted: 16 Jan 2011
Date Written: January 14, 2011
We analyze why traditional returns-based tests of market timing ability suggest in many cases that mutual fund managers evidence a negative market timing ability. The explanation is based on asymmetric correlations of stocks, which establishes that correlations are stronger in bear markets than in bull markets. This variation in stock correlations could mechanically lead to a variation in measured stock (and hence portfolio) betas in down versus up markets. We identify which stocks are more likely to increase beta in down markets and how this automatic change in betas will generate a negative bias in the market timing parameter of passively and actively managed portfolios. The paper investigates the sources of this mechanical variation in stocks’ betas that result in artificial timing ability for mutual funds. We find that a high percentage of the negative market timing ability identified for mutual funds in the literature could be explained by this bias.
Keywords: Mutual Funds, Asymmetric Correlations, Market Timing
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