Market Timing and Security Market Line Analysis

Abstract

The measure of Jensen (1968) is not only the most commonly used performance measure, but also the most heavily criticized one. Jensen (1972) and Grinblatt and Titman (1989), (1995) blame security market analysis to overestimate the beta of a market timing fund, and therefore to underestimate its performance. Admati and Ross (1985) and Dybvig and Ross (1985) show that this can occur even if the fund manager chooses a trading strategy which is efficient with respect to her superior information.

The contribution of our paper is to show that both criticisms are misleading. Neither does the Jensen measure provide an upwardly biased estimate of the outside systematic fund risk nor does it blame successful market timers to be poor performers. We first show that the "bias-in-beta" reported by Jensen (1972) and Grinblatt and Titman (1989), (1995) is not an estimation bias, but a second risk factor arising in external performance evaluation. Second, we prove that the Jensen measure of a market timer is positive if she has superior market timing information and uses this information in the interests of her shareholders. Third, the Jensen measure is shown to be the larger the better the fund manager's information is. Our results suggest that research on mutual fund performance based on security market line analysis is unbiased, regardless of whether funds are market timers or not.

Keywords: Performance, Market Timing, Mutual Fund, Security Market Line Analysis, Bias-in-Beta

JEL Classification: G11, G23