Cash-Flow Timing vs. Discount-Rate Timing: A Decomposition of Mutual Fund Market-Timing Skills

Abstract

This paper decomposes market timing skills into talents that correspond to two distinct market return components: cash-flow news and discount-rate news. Our decomposition reveals that the average U.S. domestic equity mutual fund has economically and statistically significant timing skills of about 1.2% per year: cash-flow timing contributes 2% per year in abnormal returns, while (poor) discount-rate timing generates -0.8% per year. Since aggregate cash-flow news is related to economic fundamentals, our results indicate that some managers have the ability to forecast changes in these fundamentals, and that such timing ability persists. In contrast, discount-rate news is related to changes in investor sentiment, which are largely unpredictable, resulting in slightly negative abnormal returns among some funds. We further use our timing measures to detect a subset of funds with superior timing abilities. For example, funds in the best quintile, sorted on the sum of our two timing components, exhibit about 2.5% total market timing abnormal returns over the next year. Our findings suggest that the misspecification of market timing skills in prior models accounts for the failure of prior research to find funds with significant skills in timing.