Business Cycles and Mutual Fund Timing Performance: An Application of Regime Switching and GARCH Modeling

Abstract

In this paper, we study mutual fund performance in terms of timing ability with daily data from 1998 to 2009. A novel timing model is proposed by incorporating the regime-switching framework into the Treynor and Mazuy (1966) model. The volatility follows a generalized autoregressive conditional heteroskedasticity (GARCH) process within each regime. The switching between two regimes (up and down markets) is governed by a first-order Markov process with state-dependent transition probabilities. The empirical tests are performed based on US domestic equity funds, represented by nine value-weighted portfolios based on stated investment objectives. We show that the regime switching model captures the asymmetric timing performance, whereas single regime models do not. The results of this paper show that fund managers have significant perverse timing attributes in up markets, but not in down markets. On average, institutional fund managers’ timing performance is worse than that of retail funds.