Towards a New Theory on Market Timing

Monash University Working Paper

38 Pages Posted: 28 Jul 2003  

Vijaya B. Marisetty

RMIT University; Financial Research Network (FIRN)

George Woodward

University of Colorado, Colorado Springs

Date Written: June 2003


We extend the widely used Merton (1981) market-timing model with a more realistic assumption on the information structure of the fund manager. Using a theoretically derived logistic smooth transition market (LSTM) model that incorporates duration dependence of market conditions in the transition variable to represent the fund managers' information structure, we have shown that Merton's (1981) model suffers from an oversimplification of information processing due to the simple dichotomization of market conditions. Applying our model to Australian superannuation wholesale and retail funds data we find some interesting results. First, we found that the yield spread based LSTM model fit the data best and that the behavior implied by the parameter estimates was consistent with that of a good market timer. However since yield spread fails to accurately forecast the excess market return, fund managers fail to time the market as evidenced by the fact that when fund performance was tested using the excess market return based LSTM model we found evidence contradicting the results based on the Henriksson-Merton (1981) model. Second, to investigate the extent to which the fund manager responds to yield spread we estimated the spread based LSTM model using the passive industry portfolio data provided by (SIRCA) and found that the passive industry portfolio betas are unresponsive to movements in yield spread. This lends further support to the notion that the behavior of fund managers is well represented by the spread based LSTM model. Third, we have shown that fund managers rebalance their portfolios often, not waiting for simple changes in the sign of market indicators. Finally, our model allows us to measure fund performance in terms of the speed of adjustment of beta in response to market conditions.

JEL Classification: G00, G14, G23

Suggested Citation

Marisetty, Vijaya B. and Woodward, George, Towards a New Theory on Market Timing (June 2003). Monash University Working Paper. Available at SSRN: or

Vijaya B. Marisetty (Contact Author)

RMIT University ( email )

Level 12, 239 Bourke Street
Melbourne, Victoria 3000

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane


George Woodward

University of Colorado, Colorado Springs ( email )

1420 Austin Bluffs Parkway
Colorado Springs, CO 80918-7150
United States

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