Mutual Funds Dynamics and Economic Predictors*

Abstract

We propose a new Bayesian time-varying CAPM-based beta model to analyse how mutual funds’ managers use predictors to change their betas in the short- and mediumrun. Our empirical work is based on 5,377 U.S. domestic equity mutual funds over the 1990-2005 period. The main results can be summarized as follows. First, beta dynamics are significantly affected by economic variables, although managers seem not to care about benchmark sensitivities with respect to predictors in choosing their instrument exposure. Second, persistence in beta dynamics and leverage effects are substantial while market timing has a minor role. Third and most important, we find that fund managers tend to converge towards long-run, instrument-based hedging investment strategies and that short-run predictors play a scant role. This offsets the negative market timing and produces positive Jensen’s alphas for most mutual fund categories.