Market Timing Activities Research Articles

Tracking market and non-traditional sources of risks in procyclical and countercyclical hedge fund strategies under extreme scenarios: a nonlinear VAR approach

The subprime crisis was quite damaging for hedge funds. Using the local projection method (Jordà 2004, 2005, 2009), we forecast the dynamic responses of the betas of hedge fund strategies to macroeconomic and financial shocks—especially volatility and illiquidity shocks—over the subprime crisis in order to investigate their market timing activities. In a robustness check, using TVAR (Balke 2000), we simulate the reaction of hedge fund strategies’ betas in extreme scenarios allowing moderate and strong adverse shocks. Our results show that the behavior of hedge fund strategies regarding the monitoring of systematic risk is highly nonlinear in extreme scenarios—especially during the subprime crisis. We find that countercyclical strategies have an investment technology which differs from procyclical ones. During crises, the former seek to capture non-traditional risk premia by deliberately increasing their systematic risk while the later focus more on minimizing risk. Our results suggest that the hedge fund strategies’ betas respond more to illiquidity uncertainty than to illiquidity risk during crises. We find that illiquidity and VIX shocks are the major drivers of systemic risk in the hedge fund industry.

Firm History and Managerial Entrenchment: Empirical Evidence for Vietnam Listed Firms

Managerial entrenchment occurs when managers are able to manipulate financing decisions to support their own interests rather than those of shareholders. Such possible actions can involve deception and fraud. Furthermore, the market timing activity is explained by managers' financing decisions through which companies choose to raise debt or equity to finance their investment opportunities. Nevertheless, the relationship between managerial entrenchment and leverage ratio, together with the link between market timing and leverage ratio, have not been considered carefully and investigated in the Vietnamese context. The paper provides empirical evidence of the effect of managerial entrenchment and market timing through firms' histories on leverage ratio in Vietnam using a sample of 289 non-financial firms listed on the Ho Chi Minh Stock Exchange (HOSE) during the period 2006-2017. OLS, GMM and the endogenous switching methods are used for estimating the models. Findings from the paper indicate that there is a negative relationship between managerial entrenchment and leverage ratio, and that there is a negative effect of firm history, including financial deficit, various timing measures, and stock price history on the leverage ratios of Vietnam's listed firms.

Management of flow risk in mutual funds

This paper is the first to relate the investment practices of U.S. equity mutual funds to their management of flow risk, defined as the adverse effect of investor in- and outflows on fund performance. Using a comprehensive merged sample of 2585 actively managed U.S. domestic equity funds from the CRSP mutual fund database and the SEC’s regulatory N-SAR filings, we are the first to detect differences in funds’ responses to flow risk. We find that funds using derivatives, such as options and futures on indices as well as individual stocks, have higher performance than non-using funds. We further show that this outperformance is the result of superior flow risk management using these derivatives and not a result of derivatives based stock-picking or market-timing activities. Overall, our findings document that superior flow management ability is valuable when managing open-end mutual funds and should be considered by investors and researches when evaluating fund performance.

Market Timing with ETF Options

I provide new evidence on market timing by studying ETF option holdings of hedge funds. I find that market option holdings are economically significant in terms of their impact on the market exposure of the funds. Further, I find significant time variation in market option holdings, which could be due to market timing activity. I measure market timing ability as average risk-adjusted return on market option holdings. I find that market timing ability is close to zero for the average fund but is negative for heavy option users. In the cross-section, I find that some funds have significant negative market timing ability, which I distinguish from bad luck by bootstrapping market returns.

Market timing and selectivity performance of socially responsible funds

Purpose – The purpose of this paper is to examine the market timing and stock selection abilities of socially responsible (SR) mutual funds. Some high-profile SR fund managers try to embrace market timing and security selection plans to add value to the performance. Market timing relies on forecasting the equity market and shifting assets into or out of the market in anticipation of market movements. The selectivity measure assesses fund managers ability to select undervalued securities. Furthermore, the authors examine whether fund characteristics play any role in market timing and security selection ability. Design/methodology/approach – The authors use Treynor and Mazuy's’ (1966) and Henriksson and Mertons’ (1981) model to examine the market timing and security selection ability. The study uses a decade of monthly returns to examine the skills of fund managers in the SR industry for the period from July 2002 to June 2012. Findings – The main findings are that the managers – though not very successful – do indulge in stock selection and market timing activities. It was found that 48 funds have positive statistically significant stock selectivity coefficients and only a very small number of five funds with positive statistically significant market timing coefficients. Results suggest that there is a trade-off between the two activities. It was found that aggressive funds, funds with higher growth rate and riskier funds are more likely to engage in market timing rather than stock selection. Practical implications – The implication is that SR managers cannot achieve superior stock selection and market timing ability simultaneously. Risk-averting investors in SR funds expect SR behavior from the managers. This means that managers of SR funds, with very little evidence of market timing ability, may have to refrain from market timing of SR funds. Originality/value – Using a Morningstar dataset comprising almost all SR funds in existence as of June 2012, this is probably the most exhaustive long-term study to date on market timing and stock selection abilities of SR fund managers.

Management of Flow Risk in Mutual Funds

This paper is the first to relate the investment practices of U.S. equity mutual funds to their management of flow risk, defined as the adverse effect of investor in- and outflows on fund performance. Using a comprehensive merged sample of 2,585 actively managed U.S. domestic equity funds from the CRSP mutual fund database and the SEC’s regulatory N-SAR filings, we are the first to detect differences in funds’ responses to flow risk. We find that funds using derivatives, such as options and futures on indices as well as individual stocks, have higher performance than non-using funds. We further show that this outperformance is the result of superior flow risk management using these derivatives and not a result of derivatives based stock-picking or market-timing activities. Overall, our findings document that superior flow management ability is valuable when managing open-end mutual funds and should be considered by investors and researches when evaluating fund performance.

Transaction Costs and Capital-Structure Decisions: Evidence from International Comparisons

This study examines the effect of transaction costs and information asymmetry on firms’ capital-structure decisions in 40 countries. The findings indicate that transaction costs affect both capital-market timing and capital-structure rebalancing. Past market-timing activity has a significantly negative impact on the current debt ratio, and this impact is stronger for firms facing lower transaction costs of external financing, as defined by legal origin, capital-market development, and securities rules in their home countries. Further analysis indicates that firms in countries with lower transaction costs also rebalance their capital structure more quickly after a deviation from the target, but the rebalancing does not eliminate the market-timing effect on capital structure completely.

Capital Structure Dynamics and Stock Returns

Many finance theories predict that the capital structure affects firm value, which implies that the changes in leverage have an impact on stock returns. Most of the existing literature however has been focusing on the determinants of the capital structure. Using a sample of U.S. public firms during 1975-2002, we document a significantly negative effect of leverage changes on next-quarter stock returns. This effect remains significant after controlling for other firm characteristics such as ROE, book-to-market, firm size, and past returns. We propose and test several hypotheses to explain the observed effect. We find that the negative effect is stronger for the firms with a higher leverage level. This is consistent with a dynamic view of the pecking-order model that an increase in leverage reduces firms' debt capacity and may lead to future underinvestment. Further tests confirm the negative effect of current leverage change on future investment. In contrast, our results cannot be explained by the trade-off theory, default premium, the market timing theory, or the operational signaling story. Specifically, we find that deviation from the target leverage ratio has no impact on the stock returns, inconsistent with the trade-off theory (which implies an optimal, or partially optimal, leverage ratio). In addition, the change of long-term debt affects stock returns more than the change of short-term debt, and the one-year expected return following leverage change does not increase, both of which are inconsistent with the default risk premium hypothesis. Our results are not driven by firms' market timing activities. A firm times the market by issuing new equity (repurchasing stocks) when its equity is over- (under-) valued, which implies a positive relation between the leverage change and stock return. We also do not find support for the view that leverage increase signals poor future operating performance. Finally, we show that the return effect of leverage change contains information that cannot be explained by the popular pricing factors. This sheds new light on the link between capital structure choice and empirical asset pricing.

Rapid Trading bei deutschen Aktienfonds: Evidenz aus einer großen deutschen Fondsgesellschaft

This paper is the first to examine rapid trading among German equity mutual fund investors. Using data on inflows and outflows provided by a large German mutual fund company for all of its equity funds, we find strong evidence for rapid trading. It is particularly pronounced for small funds, risky funds, funds with low nominal prices, and international funds. However, we find no evidence of market timing activities. Furthermore, unlike in the US, rapid trading is less pronounced for funds with high loads. This shows that rapid trading among German fund investors is not explained by churning due to brokers’ advice. Rather, our results are consistent with the view that some investors use mutual funds for short-term, speculative purposes. The funds among which we observe the strongest rapid trading show lottery-like characteristics. Regarding fund performance, we find (at most) only very weak evidence for a negative impact of rapid trading on fund performance before the fund scandal of 2003, and no evidence afterwards.

A Case Study of Ethics and Mutual Funds Mismanagement at Putnam

This case study examines the failure of top management at Putnam to exercise ethical behavior in the face of their clear knowledge of corruption in the company. Market timing by employees was expressly forbidden by Putnam. Six employees, including two portfolio managers, repeatedly engaged in market timing activities from 1998 to 2003, garnering over a million dollars in personal profit. The CEO and key senior executives had factual knowledge of the abuses. Management failed to stop the abuses or to discipline those involved until faced with charges from government regulators. By failing to do so, top management breached ethical duties to its shareholders and inflicted serious damage on the organization. The end results of top management's failure to address ethical violations were significant outflow of assets from Putnam's funds, payment of penalties, and loss of trust among investors. This case raises awareness about ethical issues surrounding mutual fund trading practices and the impact that top management can have on the ethical behavior of employees.

Market Timing, Growth Opportunities and Capital Structure

We examine the impact of market timing on capital structure via a measure of mispricing that is not contaminated by the level of growth opportunities. Using a decomposition of the market-to-book ratio developed by Rhodes-Kropf, Robinson and Viswanathan (2005), we show that market timing has a significant persistent impact on current leverage. Growth prospects also substantially impact firms’ leverage, consistent with traditional capital structure theories. These findings reconcile Baker and Wurgler (2002) results with subsequent studies [e.g., Kayhan and Titman (2007), Hovakimian (2006)] challenging the ability of the historical market to book ratio to adequatetly assess historical market timing activities.

Managerial Discretion and the Capital Structure Dynamics

This paper examines the effect of managerial discretion on capital structure dynamics. Analyses of financing decisions indicate that managers with more discretion prefer issuing equity over debt. Examination of leverage changes suggests that increases in debt ratios due to positive and negative financial deficits are greater for managers with high discretion. Furthermore, when managers have high‐ discretion, debt changes seem to be more sensitive to issuance activities than to repurchase activities. For high‐discretion managers, market timing activities (equity issuance following increases in stock prices) and the passive response to stock price appreciations, result in greater declines in debt ratios. Finally, while firms tend to rebalance their capital structures over time regardless of the level of managerial discretion, the speed of target adjustment is much slower for high‐discretion managers.

High Quality Bond Funds: Market Timing Ability and Performance

We examine the market timing performance of a sample of high quality corporate bond funds over the 1994-2003 time period. After establishing that the funds do engage in market timing activity, we find strong evidence of perverse market timing ability between cash and bonds and additional evidence of negative timing skill across bond maturities. A significant portion of the perverse timing ability that we detect across the fund sample is driven by the subset of funds with the highest expense ratios. Robustness tests suggest that our results reflect actual and not spurious timing ability. Overall, our results indicate that bond fund managers do not share the positive market timing ability of other groups of money managers that has been recently documented in the literature.

International Asset Allocation with Time‐Varying Investment Opportunities

This paper analyses the international equity holdings of a large panel of UK pension funds. We find considerable evidence of market timing activity, as illustrated by the funds' decision to scale back their investments in the US stock market during the 1990s. To explain this we model portfolio weight dynamics as a function of time-varying conditional moments. We find that a substantial part of the evolution in portfolio weights is explained by time-varying conditional expected returns, volatilities and covariances with domestic equity returns. Consequently, controlling for the effect of state variables that track time-variations in investment opportunities significantly affects estimates of returns from international market timing. Our estimates suggest that the portfolio movements that were orthogonal to such state variables accounted for a net loss of 0.2 per cent per annum for the average fund.

The potential for market timing abuse for mutual funds investing in the United Kingdom

The current and ongoing controversy that has come to be known as the “Mutual Fund Scandal of 2003” was based in large part on abusive market timing activities that were allowed to occur in select mutual funds. There are many ways in which amarket timer can steal profits through short‐term trading activities but the primary opportunity arises in those mutual funds that invest in foreign shares of stock. This 2004 article looks at a sampling of those mutual funds that invest in companies based in the United Kingdom and evaluates the potential for abusive market‐timing activities.

International Investment Performance: Evidence from Institutional Investors’ Foreign Equity Holdings

This paper analyzes the international equity holdings of a large panel of UK pension funds. We find considerable evidence of market timing activity, as illustrated by the funds’ decision to scale back their investments in the US stock market during the 1990s. To explain this we jointly model time-varying conditional moments and portfolio weight dynamics. Past returns do not adequately explain the funds’ international portfolio flows and only matter for the short run. Instead we find that a substantial part of the evolution in portfolio weights is explained by time-varying conditional expected returns, volatilities and covariances with domestic equity returns. However, once we control for publicly known state variables, there is no evidence of extra-market timing skills and most funds appear to have earned small but negative returns from international market timing.

On selectivity and market timing ability of U.S.-based international mutual funds: Using refined Jensen's measure

As shown in previous studies of international finance, it is well recognized that when there are no investment restrictions, diversifying into foreign capital markets reduces systematic risk significantly and provides investors with substantial gains. However, various kinds of restrictions on investments still exist and the cost of information in the international capital markets is high. One way for U.S. investors to achieve the potential gains from international diversification while minimizing the costs of information acquisition is by investing in the international mutual funds available in the U.S. market. There are approximately 50 internationally diversified mutual funds available to U.S. investors. Those international mutual funds have gained popularity not only due to the expanded foreign investment opportunities that they provide, but also due to the belief by investors that these funds outperform most of the domestic funds. Howeve& only a limited amount of research has been performed regarding international mutual fund performance (Cumby & Glen, 1990). Most of the studies regarding performance evaluation of mutual fund managers employ a method developed by Jensen (1968,1969). The Jensen measure of performance evaluation, based on the Security Market Line (SML), concentrates on a manager’s stock selection ability However, it is widely recognized that Jensen’s measure is subject to errors, especially when the manager possesses information about the market and thus engages in market timing activity Some studies have attempted to correct the bias in Jensen’s measure when timing activity exists. For example, Bhattacharaya and Pfleiderer (1983) show that an unbiased estimate is obtainable by a regression technique. Grinblatt and Titman (1989) attempted to separate selectivity and timing abilities of fund managers by proposing an alternative measure: the positive period weighing test. However, that measure is

MARKET TIMING ABILITY OF POOLED SUPERANNUATION FUNDS JANUARY 1981 TO DECEMBER 1987

Abstract:The performance of pooled superannuation funds is analysed within a framework that recognises that risk management or ‘market timing’ is an important aspect of the fund manager's decision‐making. Two broad appraoches to the issue of ‘market timing’ are adopted: first, the performance evaluation model developed by Henriksson and Merton [1981] which allows for return differentials to arise from both security selection and market timing; and second, the recursive residuals methodology of Brown, Durbin and Evans [1975] which identifies points in chronological time when the risks of the funds underwent a change.The results indicate that only 5 out of 16 funds had significant shifts in their risk over the period of the study, all of which occurred in late 1986 to early 1987. It follows that the usual Jensen measure of performance is inappropriate for these funds since one component of their performance is due to market timing activities. The return performance of these market timing activities is significantly negative for 15 to 16 funds indicating that their timing ability is perverse. To some extent this is an artifact of the market crash of October 1987 and that all funds had a positive exposure to equities. However, due to their asset allocation policies all funds are assigned significantly positive security selection performance.

The Investment Performance of Mutual Funds: An Empirical Investigation of Timing, Selectivity, and Market Efficiency

The empirical evidence in Jensen (1968, 1969) is consistent with the joint hypothesis that the Sharpe (1964)-Lintner (1965)-Mossin (1966) (hereafter referred to as SLM) capital asset pricing model is valid and that mutual fund managers on average are unable to forecast future security prices. These studies have been cited as support for the strong form of the Efficient Markets Hypothesis (EMH);' that is, whether any investor has monopolistic access to any information relevant for price formation. In recent years the capital asset pricing model has undergone extensive empirical investigation. Friend and Blume (1970) generated random portfolios from New York Stock Exchange securities to determine the usefulness of risk-adjusted performance measures. They discovered that these performance measures are dependent upon This paper evaluates mutual fund stock selectivity performance and the implications for the Efficient Markets Hypothesis (EMH) when management is simultaneously engaged in market timing activities. Both the SharpLintner-Mossin and Black models of market equilibrium are employed as benchmarks. The empirical evidence indicates that many of the funds in the sample significantly change their risk levels during the measurement interval. This behavior also results in significantly different stock selectivity performance and portfolio diversification. The evidence on selectivity performance pertinent to the EMH is mixed. * The authors are grateful to A. Chen, D. Hester, J. Hickman, N. Kiefer, E. H. Kim, P. Lau, M. Miller, E. Parzen, L. Rosenthal, G. Schlarbaum, M. Scholes, and especially M. Hartley and R. Haugen for helpful comments and discussions. This paper has also benefited from comments by an anonymous referee and discussions with participants of the Finance Workshops at the University of Chicago, State University of New York at Buffalo, and the University of Wisconsin-Madison. The first author was visiting the Graduate School of Business at the University of Chicago during this project and gratefully acknowledges their financial support. 1. For example, see Fama 1970, pp. 410-13.