Market Timing, Selectivity, and Mutual Fund Performance: An Empirical Investigation Author(s): Cheng-Few Lee and Shafiqur Rahman

Reviewed work(s): Source: The Journal of Business, Vol. 63, No. 2 (Apr., 1990), pp. 261-278 Published by: The University of Chicago Press Stable URL: http://www.jstor.org/stable/2353219 . Accessed: 09/01/2013 06:04
Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp

.
JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.

The University of Chicago Press is collaborating with JSTOR to digitize, preserve and extend access to The Journal of Business.

http://www.jstor.org

This content downloaded on Wed, 9 Jan 2013 06:04:06 AM All use subject to JSTOR Terms and Conditions

Cheng-few Lee
Rutgers University

Shafiqur Rahman
Portland State University

Market Timing, Selectivity, and Mutual Fund Performance: An Empirical Investigation*

I. Introduction
This article empirically examines market timing and selectivity performance of a sample of mutual funds. It uses a very simple regression technique to separate stock selection ability from timing ability. This technique, first suggested by Treynor and Mazuy and later refined by Bhattacharya and Pfleiderer, uses a modified security-market line approach to produce individual measures of timing and stock selection ability. The inputs to the model are only the returns earned on the fund and those earned on the market portfolio. The empirical results indicate that at the individual fund level there is some evidence of superior micro- and macroforecasting ability on the part of the fund manager.

The investment performance of mutual fund managershas been extensively examined in the finance literature. Most of these studies employed a method developed by Jensen (1968, 1969) and later refined by Black, Jensen, and Scholes (1972) and Blume and Friend (1973). Such a method compares a particularmanager's performance with that of a benchmark index fund. Such investigations assume that the risk level of the portfolio under considerationis stationary throughtime, and they exclusively concentrate on a fund manager's security selection skills or lack thereof. One weakness of the above approach is that it fails to separate the aggressiveness of a fund manager from the quality of the informationhe possesses. It is apparent that superiorperformanceof a mutualfund manager occurs because of his ability to "time" the market(markettiming)and/orhis ability to forecast the returns on individual assets (selection ability). Indeed, portfoliomanagersoften charac* We appreciate an anonymous reviewer's helpful comments and valuable suggestions, which have added significantly to the clarity of presentation in this article. We also appreciate editor Albert Madansky's encouragement while we were revising the article. We thank Michael Gibbons for providing us with the mutual funds data base and Janet Hamilton and John Settle for helpful discussions and comments. (Journal of Business, 1990, vol. 63, no. 2) ? 1990 by The University of Chicago. All rights reserved. 0021-9398/90/6302-0006$01 .50 261

This content downloaded on Wed, 9 Jan 2013 06:04:06 AM All use subject to JSTOR Terms and Conditions

262

Journal of Business

terize themselves as markettimers and/or stock pickers. Jensen (1968) acknowledgedthe ability of the fund managersto change the risk level of theirportfolios. Indeed, the portfoliomanagersmay shift the overall risk composition of their portfolios in anticipationof broad marketprice movements. Fama (1972)and Jensen (1972)addressedthis issue and suggested a somewhat finer breakdownof performance. The purpose of this article is to examine empirically the market timing and selectivity performanceof a sample of mutualfunds. Section II discusses two components of investmentperformance.Section III discusses various attempts to model these two components and relevant empirical works to date. Section IV reports results of our empiricalwork. Section V concludes the article.
II. Identifying Timing and Selection Ability

Fama (1972)suggested that portfoliomanagers'forecastingskills could be partitioned into two distinct components: (1) forecasts of price movements of selected individualstocks (i.e., microforecasting); and (2) forecasts of price movementsof the generalstock marketas a whole (i.e., macroforecasting).The former is known as "security analysis" while the latteris called "markettiming."This partitioning of forecasting skills is also evident in Treynorand Black (1973), who have shown that portfoliomanagerscan effectively separateactions relatedto security analysis from those related to markettiming. Microforecasting,or security analysis, involves the identification of individualstocks that are under- or overvalued relative to equities in general. Within the specification of the capital asset pricing model (CAPM), a microforecasterattempts to identify securities whose expected returnslie significantlyoff the securitymarketline. Specifically, the microforecaster would only forecast the nonsystematicor securityspecific componentof security return.FollowingJensen (1972, p. 132), the excess returnon a portfolio can be written as
RP=
f3P Rm +
et,

(1)

whereRPP is the excess (net of risk-freerate)returnon pth portfolio,Rm is the excess (net of risk-free rate) returnon the marketportfolio, P3 measuresthe sensitivity of the portfolioreturnto the marketreturnand
etP

is a random error, which has expected value of zero. Within this

framework,microforecastabout pth portfolio would involve concentratingon et. If the portfoliomanageris a superiorforecaster(perhaps because of special knowledge not available to others) he will tend to select securities that realize JP > 0. Hence his portfoliowill earn more than the "normal" risk premiumfor its level of risk. Allowance for such forecasting ability can be made by simply not constrainingthe estimatingregression to pass throughthe origin. That is, we allow for

This content downloaded on Wed, 9 Jan 2013 06:04:06 AM All use subject to JSTOR Terms and Conditions

Market Timing

263

the possible existence of a nonzero constant in equation(1) as follows:

RP = otP + P Rm + 0P (2)

The new errorterm, tv', will now have expected value of zero. Thus if the portfolio manager has an ability to forecast security prices, the interceptoW in equation(2) will be positive. On the one hand, a passive strategy(randombuy-and-holdpolicy) can be expected to yield a zero intercept. On the other hand, if the manageris not doing as well as a randomselection buy-and-hold policy, &' will be negative. Such results may very well be due to the generationof too manyexpenses in unsuccessful forecastingattempts. Macroforecasting or markettimingrefers to forecasts of future realizations of the market portfolio. A macroforecasterwill attemptto capitalizeon any expectationhe may have regardingthe behavior of the marketreturnin the next period. If the managerbelieves he can make better than averageforecasts of market returns,he will adjusthis portfolio risk level in anticipationof market movements. If successful, he will earn abnormalreturnsrelativeto an benchmark.For example, if, on the one hand, the manager appropriate (correctly)perceives that there is a highprobability that marketreturns will be up next period, he will be able to increase the return on his portfolioby increasingits risk. On the other hand, if the marketreturn is expected to be down next period, he can reduce the losses on the portfolioby reducingthe risk level of the portfolio. Indeed, the market timerswitches from more risky to less risky securities(or vice versa) in an attemptto outguess the movement of the market.We can allow for the existence of timingabilityin equation(2) by permitting the sensitivity coefficient (3P) to be stochastic. Market-timing ability will be present where III.
3

and R, are positively correlated.

A Model of Market Timing and Selectivity

It is importantthat fund managersbe evaluatedby both selection abilskill. Accordingly, it is necessary to model timity and market-timing ing and selectivity simultaneously.Jensen (1968)demonstrated that, in the presence of market-timing ability, the estimatedrisk parameter (3P) in equation(2) will be biased downwardand the estimatedperformance measure (&x)will be biased upward.Grant(1977)explained how market-timingactions will affect the results of empiricaltests that focus only on microforecastingskills. He showed that market-timing ability will cause the regressionestimate of of' in equation(2) to be downward biased.'
1. Grant (1977) showed that, given Jensen's (1968) assumptions, the least-squares estimator of PP is an upward-biased estimate of the expected value of PP, and therefore his performance measure represents downward-biased, not upward-biased, estimates of performance. See Grant (1977, p. 843) for details.

This content downloaded on Wed, 9 Jan 2013 06:04:06 AM All use subject to JSTOR Terms and Conditions

264

Journal of Business

Treynorand Mazuy (1966)added a quadraticterm to equation(2) to test for market-timing ability. In the standardCAPM regressionequation, a portfolio's return is a linear function of the market return. However, the authors argue that if the managercan forecast market returns,he will hold a greaterproportionof the marketportfoliowhen the return on the market is high and a smaller proportionwhen the returnon the marketis low. Thus, the portfolioreturnwill be a convex function of the market return. Using annual returnsfor 57 open-end mutualfunds, they find that the hypothesis of no market-timing ability can be rejected with 95%confidence for only one of the funds. Jensen (1972) developed theoretical structuresfor the evaluationof micro- and macroforecasting performanceof fund managerswhere the basis for evaluation is a comparisonof the ex post performanceof the manager'sfund with the returnson the market.Jensen definedfr, to be - E(Rm),where E(R'")is the expected value of RA" unconditional Rand fr* is the expected value of rr, condiupon any special information tional upon t,, the informationset available to the manager at the beginningof the period. Assume that the portfolio is managedin the interest of a group of investors who have constant absolute risk aversion of an unknowndegree. Given the objectiveof the managerand the assumption that the conditional distributionof ftt is normal, Jensen showed that Pt _3
+

f t*,

(3)

where f3P is the "targetbeta" of the fundand 0 measuresthe manager' s response to his information.Above, and in the sequel, we place a time subscriptupon PPas the value is assumed to change over time. If the investorsin whose interestthe fund is being managedhave a coefficient
of absolute risk aversion equal to a, 0 will equal 1/[a
var(f,/rt/)]

and PT

will equal 0 E(Rm)(see Bhattacharyaand Pfleiderer1983, p. 8). In the Jensen analysis, the market timer is assumed to forecast the actual returnon the market,and the forecastedreturnand the actualreturnon the market are assumed to have a joint normal distribution.Jensen shows that, underthese assumptions,a markettimer'sforecastingability can be measured by the correlationbetween the market timer's forecast and the realized returnon the market (see Jensen 1972, pp. 317-18; Treynorand Black 1973).Jensen writesfor an optimalforecast
,t

=- t + v,

(4)

and assumes that ii, is normallydistributedand independentof frt. He then writes equation (2) as
RP== otP +

[P3P +

O(fTt

+ V )][E(Rm)

ftt] + UP.

(5)

This content downloaded on Wed, 9 Jan 2013 06:04:06 AM All use subject to JSTOR Terms and Conditions

Market Timing

265

on a constant, fTt, and iTt: Considerthe regression of RP7

RP =
no

lt

t+U

(6)

Jensen (1972) claims that ' = oP + plim Pr-E(Rm) + O(p2_

plim p
= p2

1)U2,

(7) (8)
(9)

OE(Rm) + m39

and
plim
=

where p is the correlationbetween the predictionand the realizationof

ftt

and

a2 is

the variance of

frt.

This system has more unknowns than

numberof equations. Jensen concluded that, under the above struccan not be ture, separatecontributionsof micro-and macroforecasting identifiedunless, for each period, the markettimingforecast andE(Rm) are known. Merton(1981)and Henrikssonand Merton(1981)have attemptedto overcome some of the problemscaused by lack of a precise estimateof E(Rm).Their model differs from the Jensen (1972)formulationin that their forecasters follow a more qualitativeapproachto markettiming. Namely, the market timer forecasts either that stocks outperform bonds or vice versa. The forecasters in this model are less sophisticated than those of Jensen (1972), where they do forecast how much better the superior investment will perform. They assume that managers have a coarse informationstructurein which dichotomous signals are only predictive of the sign of the excess returnof the market relativeto the risk-freerate. In theirmodel, the probabilityof receiving an "up" or a "down" signal in no way depends upon how far the marketwill be "up" or "down." Changand Lewellen (1984)and Henmodel in evaluating riksson (1984) employed the Merton-Henriksson mutualfund performanceand found no evidence of markettimingby fund managers. Bhattacharyaand Pfleiderer (1983) extended the work of Jensen (1972). By correcting an error made in Jensen (1972), they show that one can use a simple regressiontechniqueto obtainaccuratemeasures of timing and selection ability.2The authorsassume that the manager
2. In deriving the probability limits of i0, I, and i2, Jensen implicitly assumed independence between fr, and i,. This is not true. Since frt*and fr, are jointly normally distributed, it is possible to write
=do*

+ d***

+ i,*

If -ft*is the optimal forecast, where v,* is normally distributed and independent of frT*. do*= 0 and dt = 1. However, if we write
=

do + dlf,

v,,

independent of fr,. we cannot have do and d, equaling zero and unity, respectively, and v3,

This content downloaded on Wed, 9 Jan 2013 06:04:06 AM All use subject to JSTOR Terms and Conditions

266

Journal of Business

observes at the beginning of period t a signal, ftt + it, where it is a mean-zeronormaldeviate that is independentof ftt. It is easy to show that the optimalforecast iS3
=

i1i=

frt

t)

(10)

where
=

2/ C +

(11)

and u2 iS the variance of t. Using equation (10) and the relationships mentionedearlier, that rP = 0 E(Rm) and ftt = R - E(Rm), we can rewrite equation (2) as
- E(Rm) + it]}(R7m) + RP = o&P+ 0{E(Rm) + it,[R7m O.

(12)

we get Rearranging,
RP = oxP + OE(Rm)(1 - iJ,)R7m+ 40(R7)2 + OitR7m + a, (13)

and
t=

no +

m TjRR

mR7)2 + Co'

(14)

The relationshipin equation(14) is similarto one suggestedby Treynor and Mazuy (1966)and is in terms of observablevariables.If we runthe
3. We want to set ij to minimizethe varianceof the forecast error: min E[iTtor
(4fTt+ it)]2

minE[VT2 - 2*tt4(*, +
or

+ it)2], it) + %i2(iTt

minE(-fr2'p

ti - 2*titt 2IfT2

+ 22,fTt,t + + qp2rT2

p2i2).

Since E(tr,)

E(i,)

E(frttt) = 0, we have

min E(*2 or

- 2ft2q

+ t2ft2

+ 4 20,

min E[(1 or
min (1
-

)2-2 + q2],

4t,)2Ur2 +

p2(f2

The first-order conditionis

-2(1
-

't0f +

24iu2 = 0,

' =

=2/(cr +

oE).

This content downloaded on Wed, 9 Jan 2013 06:04:06 AM All use subject to JSTOR Terms and Conditions

Market Timing

267

quadratic regression given by equation (14), the large-samplecoefficient estimates are

= plim o14

(15)
i),

plim

= O OE(Rm)(I-

(16)

and plim i2
=

04u.

(17)

The above regression allows us to detect the existence of stock selecNow consider the disturbanceterm in tion ability as revealed by o&P. equation (14): (18) = Og,tRt + atP* The first term in Co'contains the informationneeded to quantify the by regressing manager'stimingability. We can extract this information
co,
(t) ((),t)2
o

on

Rm)2:

(.),)2

024v2a2 (Rtm)2

Zt,

(19)

where
02= O2(R)2(i2

_ U2) + (atp)2 + 20R,miteUP

(20)

The proposed regression produces a consistent estimator of O22EA2. which we recover from equation Using the consistent estimatorof 04u, (14), we obtain o2 . This, coupled with knowledgeabouto2, allows us to a2 /(I(2 + or) = p2. Finally, we calculate p, which truly estimate = measures the quality of the manager'stiming information.4

4. We will ignore the negative correlation. Bhattacharya and Pfleiderer (1983) argued that negative correlation between the prediction and the realization of fr, would imply that the fund manager possessed timing information that had positive value but that the manager was misguided by its application. Another manager would do well to take positions opposite of those taken by the misguided manager. We rule out the possibility that there exist managers who are both well informed and foolish. Admati et al. (1986) extended the work of Bhattacharya and Pfleiderer (1983). They offer two basic modeling factor approach and the portfolio approaches to identify timing and selectivity-the approach. The portfolio approach is simply a generalization of the Bhattacharya and Pfleiderer (1983) model. In the factor approach, a factor-generating process is postulated for asset returns, and timing and selectivity information are interpreted in terms of their statistical relation to the factors and to the idiosyncratic terms in the generating process, respectively. It is possible to recover the appropriate measures of the quality of both the timing and selectivity information. In this approach, it is not necessary to assume any particular asset-pricing model to identify the information quality of a manager. However, because of the larger number of interactions between information signals and asset returns, this approach requires an extremely large number of regressors in the estimation equation and, most likely, this exceeds the number of time-series observations obtainable for any fund. For this reason, estimation of the quality parameters of the timing and selectivity information seems to be possible only when the number of time-series obser-

This content downloaded on Wed, 9 Jan 2013 06:04:06 AM All use subject to JSTOR Terms and Conditions

268

Journal of Business

It should be noted that the procedure discussed above does not produce the most efficient estimates of the parameters since the disturbance term in equations (14) and (19) are heteroscedastic. More efficient estimates can be obtained by taking into account the heteroscedasticity of the disturbance terms. IV. Empirical Results

To detect selection ability and market-timing ability of a mutual fund manager, monthly returns for 87 months (January 1977-March 1984) for a sample of 93 mutual funds were used. A list of funds in the sample, including the objective of the individual funds, is presented in the Appendix. The monthly rate of return on the Center for Research in Security Prices (CRSP) value-weighted index (including dividends) was used for market return. Monthly observations of the 91-day Treasury bill rate was used as a proxy for the risk-free rate. All returns are measured as continuously compounded rates of return. To detect the quality of the manager's timing information, we need an estimate of the variance of *,. Merton (1980) presented a simple technique of estimating the variance of ft, from the available time series of realized return on the market under the assumption that ft, follows a stationary Wiener process. The advantage of this estimator is that the variance can be estimated without knowing, or even having an estimate of, the mean. It also, of course, saves one degree of freedom. A reasonable estimate of r92 was derived as follows: n
Um=

[ln(1 + R )]2j/n.

(21)

Because the estimator for o2 is not taken around the sample mean, &r2 will be biased. However, for large n, the difference between the second
vations is impractically large. Althoughthe factor approachhas conceptualadvantages over the portfolio approach, identificationof informationquality is easier under the portfolioapproachthan it is underthe factor approach.The work of Bhattacharya and Pfleiderer (1983)has been conductedin the context of a model with privateinformation where equilibriumis determinedaccordingto the CAPM that assumes homogeneous beliefs. Such analysisimplicitlyassumesthat fundmanagers,who mightnot sharethese homogeneousbeliefs, do not effect equilibrium. AdmatiandRoss (1985)arguedthatthis is somewhat disturbingsince there is no reason to believe either that the bulk of the markethas the same beliefs or thatthe combinedeffect of managed portfolioson equilibrium is zero. In contrast, they developed a model that includes many agents with heterogeneous and asymmetric information.These agents are perfectly rational and optimallyuse all the informationavailableto them, includingprices. Their model is a noisy rational-expectations equilibrium capitalasset pricingmodel. Under some conditions, the Bhattacharya and Pfleiderer (1983)modelcan be treatedas a specialcase of the Admatiand Ross (1985)specification.However, the Admatiand Ross (1985)analysisis still preliminary. To develop a completestatisticalmodelthatis consistentwith observation of a time series, a multiperiod modelis required,fromwhich the propertiesof such time series can be derived. This is a difficulttask, especially in the context of rationalexpectationsequilibrium models.

This content downloaded on Wed, 9 Jan 2013 06:04:06 AM All use subject to JSTOR Terms and Conditions

Market Timing

269

'2 centraland noncentralmoments is trivial. In our case, U7r as estimated in equation (21) was .0018633, while the sample variance of frt was .0018444. In order to obtain efficient estimates of parameters,a generalized least squares (GLS) procedure,with correctionfor heteroscedasticity, is used. The correctionfor heteroscedasticityis of the followingform. We first derive the variance of the error terms in equations (14) and (19). These are
2=

2qj2 2u(R m)2 +

o2

(22)

and
r2 = 204q]4(R m)4cr4+ 2cr4 + 402qJ2ur2(Rj)2ur2

(23)

where cr2, cr, and cr2are variancesof Co",tp, and Zt, respectively.5 To predict or2 and uo2,we need estimates of uo2and c2 . An estimateof o2 iS obtained by using equations (14) and (19) in the mannerdescribed in Section III, while an estimate of o2 is obtained by using equation(2). The variables in equations (14) and (19) are divided by U2 and o2, respectively, and an ordinaryleast squares(OLS) procedureis applied to the transformed observationsto obtain the most efficientestimates. Table 1 presents regression results. These results show some evidence of selectivity and markettimingat the individualfund level. Out differentfrom zero of 93 funds, 24 funds (25.81%)have aP significantly at the .05 level. Fourteen of these funds (15.05%)have positive OtP. Sixteen funds (17.2%)have p significantlydifferentfromzero at the .05 level. The correlationbetween otPand p is .47. This implies that the funds do not exhibit a considerable degree of specialization in one forecasting skill. Ten funds have both significantselection and timing skills. Four funds have significantselection skill with no timing skill while five funds have significanttiming skill with no selection skill. Table 2 presents summary results. For comparison, it also presents results obtained without correction for heteroscedasticityand results obtained by using Jensen's (1968)originalspecification,which ignores markettiming. Apparently,there is some differencein the results with and without correction for heteroscedasticity. Correctionfor hetero5. Equation(23) is derived as follows:
= [O22(R,7)2]2var(, a = 0444(R1&)4var(2) -

_3 + var[(tP)2] + (20 4R7')2var(i,O)

+ 4024i2(R7&)2(o2(

+ var[(ap)2]

= 204+4 (R -)4(T4 + 2T4, + 40242(R7&)2(T2(T2

Here var(i2), var[(ap)2], and var(i,uO) have been derivedfollowingStevens (1971).The author showed that the variance of the product of two random variables (x and y) is 2rar(1 + p + I2(3-2 + y2(r2 +2xy
9 PxVTVrTN

where x and y are expected values and p, is the correlation coefficient between x and y.

This content downloaded on Wed, 9 Jan 2013 06:04:06 AM All use subject to JSTOR Terms and Conditions

270 TABLE 1 Fund No. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56

Journal of Business Estimated Parameters for Individual Mutual Funds Selectivity

(otP)

Timing (p) .020132 .335453* .066912 .022494 .067333 .169254 .063949 .038000 .170767 .081222 .095340 .102088 .074079 .237678* .168343 .007486 .190182 .400737* .274264* .080037 .219963* .123008 .075288 .125399 .147792 .065447 .041892 .026715 .140325 .071318 .226560* .079312 .099352 .104514 .086810 .049843 .030302 .164544 .037160 .163631 .097798 .300712* .161170 .059656 .156354 .460663* .040750 .197276 .132463 .075589 .032803 .024250 .029640 .044560 .047015 .016250

Risk Tolerance (1/a) .475268 .081501 .136940 .351466 .330754 .031218 .427938 .756942 .057663 .098679 .276882 .165274 .299354 .067420 .101970 2.780619 .032486 .019152 .037201 .095757 .058373 .089942 .169693 .166441 .068880 .190942 .282091 .547288 .456735 .175987 .053163 .540525 .149792 .144536 .210635 .410531 .498297 .103227 .378385 .251961 .303047 .040404 .120046 .313446 .225221 .024265 .187328 .067522 .083094 .154985 .580112 .481311 .591821 .349736 .426819 1.164849

.000478 .006653 .003639* -.001667 -.002925 -.001884* .001113 .001426 -.003167 -.000007 -.002307 -.001732 - .003723 .006082* .000281 .000320 - .002209 .005322* .002481 .000224 .004423* - .003189 .000776 .001709 - .007199* .003517 .000816 - .006435* .026101* .000359 - .005553* .000320 .001068 - .004555 - .001128 - .001417 - .001768 - .004186 - .005178 .001900 .001681 .002433 .003828 -.000574 .009882 .013015* -.000676 - .006713* .003260 .001701 - .001283 - .001220 - .002234 - .004298 - .003708 - .002843

This content downloaded on Wed, 9 Jan 2013 06:04:06 AM All use subject to JSTOR Terms and Conditions

Market Timing TABLE 1

Fund No.

271 (Continued) Selectivity

(OLP)

Timing
(p)

Risk Tolerance
(1/a)

57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93

.001262 .001998 .011764* - .000793 .001997 - .003425 .003324 - .006290* - .001598 .002601* .007745* - .010029* .002687 - .002058 -.004360 .009806* - .000085 - .003531 - .001547 .000112 - .000801 - .007927* - .005650* - .001381 - .001951 .007862* .013417 - .001073 .022220 .008511* .005592* .013559* - .004381* - .002031 .001323 - .001994 - .000512

.050319 .270515* .227052* .058885 .047408 .041408 .199712 .158683 .096472 .083389 .271983* .048784 .293644* .057089 .014077 .310578* .110481 .135722 .143489 .151980 .030183 .019138 .062168 .037569 .080268 .322760* .156453 .036027 .102765 .255405* .195902* .346244* .196457 .095676 .024031 .039311 .058520

.196002 .056642 .069113 .183894 .321910 .263968 .048909 .066722 .129843 .091243 .072374 .317378 .030178 .271960 1.355227 .074121 .054277 .102294 .055442 .056659 .395270 .606536 .313203 .496102 .163958 .038147 .482895 .289643 .810111 .084736 .082124 .059402 .027485 .117306 .517189 .375321 .145089

NOTE.-Funds are identified by number in the Appendix. * Significant at the .05 level.

scedasticity significantlyaffects the conclusions. Our results are consistent with Breen, Jagannathan, and Offer(1986).The authorsshowed that the test of markettimingthat ignoresheteroscedasticityrejectsthe null hypothesis of no markettiming too often, when, in fact, the null hypothesis is true. Table 2 has other interestingevidence. The estimate of cfPtends to be slightly lower when timingis ignored.This is consistent with Grant's(1977)contentionthat Jensen's performance measure will be downwardbiased when timingis ignored. A similarconclusion was drawnby Chang and Lewellen (1984)and Henriksson (1984). We computed each fund's risk-tolerancecoefficient, which is the

This content downloaded on Wed, 9 Jan 2013 06:04:06 AM All use subject to JSTOR Terms and Conditions

272 TABLE 2 Summary Statistics for Mutual Fund Performance Selectivity (ox P) Model Market timing ignored Market timing considered: Without correction for heteroscedasticity With correction for heteroscedasticity
*

Journal of Business

Timing (p) Mean ... .1696 .1231 Positive ... 28* 16*

Mean - .0005 .0011 .0008

Positive 4* 15* 14*

Negative 9* 9* 10*

Significantly differentfromzero at .05 level.

reciprocal of the Pratt-Arrowmeasure of absolute risk aversion, a.6 Since each fund is managedfor a groupof investorswith a specificrisktolerance coefficient, by selecting a fund, the investors provide information about their risk tolerance. The risk-tolerancecoefficient indicates the investor's (or fund manager's)willingness to accept greater risk in orderto earn a greaterexpected reward.The lower (higher)the risk tolerance, the more conservative (aggressive)the asset mix. These coefficients can be used to rank the funds in order of their aggressiveness. The estimated risk-tolerancecoefficients (1/a) are displayed in the finalcolumn of table 1. These coefficients rangefrom .019152to 2.7806 with a sample mean of .27429.The risk-tolerance coefficientfor the individualfunds can be used to ascertainthe average size of risky investment in the fund, that is, the asset allocation between riskless asset and risky investment(marketportfolio).The averagesize of risky investment in the fund (as a fraction of total net assets of the fund) is given by
W
=

(Ila)[E(Rm)/2Ur2],

(24)

6. We thank an anonymous reviewer for suggestingthis work. The risk-tolerance

coefficient (1/a) is derived directly from f) as follows: using eq. (17) and the previously mentioned relationship that 0 = 1la var(*r/l,), we have f = 14a l varQfrI4,),where a is the

coefficientof absolute risk aversion. From n. 4 above, + qj2 Dj2 var(*r/4,)= (1 - o)2
=
=
U2-

-_ 2ij,4
02f

+ ku2u2+ q2ur2
+ q2(U2

a3.

Using

4/(Cr2 + a.),
var(*/I,) = 'T2 = 'T-

2 ql'2
'Tr

q2W2 /q

= =
=

42(1 'r4
J(Je2

Ofu) 2 + (re)

2/ (or

in the expressionfor -2, we have Now, substituting42for var(wr/4,) . rangingthe terms give 1/la -=

Il 1a

a2.

Rear-

This content downloaded on Wed, 9 Jan 2013 06:04:06 AM All use subject to JSTOR Terms and Conditions

Market Timing

273

where ua, is the varianceof marketreturn.7Table 3 presents the average size of risky investmentgiven by equation(24). It also presents the actual percentage of fund assets invested in risky assets (assets other than cash and government securities) as reported by Wiesenberger InvestmentCompaniesService. The sample correlationcoefficientbetween average size and actual size is .26 with a t-statisticof 2.32. This is significantat the .05 level. V. Conclusion This article discusses conceptual and econometric issues associated with identifying two components of mutual fund performance.The empirical results obtained using the technique developed by Bhattacharyaand Pfleiderer(1983)indicatethat at the individuallevel there is some evidence of superiorforecastingabilityon the partof the fund manager.This result has an importantimplication.Funds with no forecasting skill might consider a totally passive managementstrategyand just provide a diversificationservice to their shareholders.Ourresults indicate a substantialimprovementover previous attemptsto evaluate fund managers. Kon (1983) empiricallyexamined the performanceof mutualfunds. Of those 37 funds, 14 had overall timing estimates that were positive, but none was statisticallysignificant.Recently, Connor and Korajczyk (1986) developed a method of portfolio performance measurementusing a competitive version of the arbitragepricingtheory (APT). However, they ignored any potential market timing by managers. Lehmann and Modest (1987) combined the APT performance evaluation method with the Treynor and Mazuy (1966) quainvests W 7. This derivationfollows Sharpeand Alexander(1989).The fund manager fractionof fund assets in marketportfolioand (1 - W) fractionin risk-freeasset. The expected excess return[E(RP)] and varianceof return(a,) on the portfolioare
E(RP) = WE(h-)(i)
aD2 = W2DM. (ii)

the result in eq. (ii) yields Solving eq. (i) for W and substituting
ap2

= [E(RP)E(Rm)]2(M.

(iii)

Equation(iii) describes the functionalrelationshipbetween the expected excess return and the varianceof returnon the portfolio.Its slope,
dE(RP)/dap = l/[dap2dE(RP)] = [E(Rm)]212E(RP)o.T,
(iv)

equals the slope of the indifferencecurve (betweenmeanand variance)of the fund (and each of its investors). For constantrisk tolerance,the latterslope is equalto the inverse of the risk-tolerance coefficient. This implies
a = [E(Rm)]212E(RP)U7m. (v) (vi)

side of eq. (i) for E(RP) in eq. (v) results in Now, substituting the right-hand
a = E(Rm)12 WM.

Next, solving eq. (vi) for W results in eq. (24).

This content downloaded on Wed, 9 Jan 2013 06:04:06 AM All use subject to JSTOR Terms and Conditions

274 TABLE 3 Fund No. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 Size of Risky Investment in the Individual Funds Average (%)* 45 79 41 35 61 46 43 45 51 35 28 34 44 42 50 49 35 48 28 38 49 49 32 41 51 56 51 56 46 47 52 73 45 13 18 18 26 50 48 58 85 40 63 20 18 38 45 56 41 30 25 34 16 22 17 14

Journal of Business

Actual (%)t 95 97 85 92 86 92 87 95 94 87 49 91 88 N.A. 87 83 92 90 38 N.A. 81 94 N.A. 75 98 96 90 N.A. 86 87 88 78 74 73 82 90 87 85 95 95 96 N.A. 92 95 N.A. 96 90 91 N.A. 91 N.A. N.A. 94 92 N.A. 95

This content downloaded on Wed, 9 Jan 2013 06:04:06 AM All use subject to JSTOR Terms and Conditions

Market Timing TABLE 3 Fund No. 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 (Continued) Average (%)* 49 65 26 48 53 44 51 53 39 44 40 11 49 52 17 28 45 61 42 28 38 28 49 61 44 45 87 38 52 58 43 73 50 48 43 22 36 Actual (%)t 89 96 90 91 83 89 96 93 84 74 N.A. 69 90 N.A. 90 89 N.A. N.A. 94 76 95 87 86 88 N.A. 92 93 81 N.A. 92 83 88 N.A. 94 96 97 93

275

NOTE.-Funds are identified by number in the Appendix; N.A. = not available. * Reflects value given by eq. (24). t Reflects actual fraction of fund assets invested in risky assets (assets other than cash and government securities).

dratic regression technique. Their findingsare consistent with our results. They found statistically significantmeasured abnormaltiming and selectivity performanceby mutualfunds. They also examinedthe impactof alternative(CAPMand a variety of APT) benchmarkson the performanceof mutualfunds. They found that performancemeasures are quite sensitive to the benchmarkchosen. The authorsfound a large number of negative selectivity measures. Also, Kon (1983) and Henriksson (1984) found a negative correlationbetween the measures of and Korajczyk(1986)arguedthat selectivity and timing. Jagannathan

This content downloaded on Wed, 9 Jan 2013 06:04:06 AM All use subject to JSTOR Terms and Conditions

276

Journal of Business

such results could arise from artificialmarkettimingdue to the differential leverage of the firms in the indices and those invested in by the mutualfunds. They theoreticallyand empiricallydemonstratedhow to create a portfoliothat would exhibit positive (negative)timingperformance and negative (positive) security selection when no true timingor selectivity exists. However, unlike the predictionsin Jagannathan and Korajczyk (1986), Lehmann and Modest (1987) found no systematic evidence that funds with large negative quadraticterms have large positive intercepts. Specifically, they were unable to detect any substantive correlation between intercepts and the coefficients on the squaredterms.
Appendix
TABLE Al List of Mutual Funds

Fund Name 1. AffiliatedFund 2. AmericanInvestors Fund 3. AmericanMutualFund 4. Axe-HoughtonFund B 5. Axe-HoughtonStock Fund 6. BullockFund 7. Canadian Fund 8. CenturyShares Trust 9. ChemicalFund 10. ColonialFund 11. CommerceIncome Shares 12. CompositeBond and Stock Fund 13. CompositeFund 14. ConcordFund 15. De Vegh MutualFund 16. DelawareFund 17. Dodge and Cox BalancedFund 18. Dreyfus Fund 19. Dreyfus Special Income Fund 20. Eaton Vance Investors Fund 21. EnergyFund 22. Fidelity Fund 23. Fidelity PuritanFund 24. FinancialIndustrialFund 25. FoundersMutualFund 26. GrowthIndustryShares 27. Guardian MutualFund 28. HamiltonFund 29. International Investors 30. InvestmentCompanyof America 31. InvestmentTrust of Boston 32. InvestorsResearch Fund 33. Istel fund 34. Keystone CustodianFunds B-1 35. Keystone CustodianFunds B-2 36. Keystone CustodianFunds B-4 37. Keystone CustodianFunds K-1 38. Keystone CustodianFunds K-2

Objective G, I MCG G, I, S S, I, G G G, I G G G G, I G, I I, S, G G, I, S MCG G G, I I, G, S G I, G, S G, I, S G G, I I, G G, I G, I G G, I G, I G, I G, I G, I G G, I I I I I G

This content downloaded on Wed, 9 Jan 2013 06:04:06 AM All use subject to JSTOR Terms and Conditions

Market Timing TABLE Al (Continued)

277

Fund Name 39. Keystone CustodianFunds S-1 40. Keystone CustodianFunds S-3 41. Keystone CustodianFunds S-4 Fund 42. Keystone International 43. Loomis-SaylesCapitalDevelopmentFund 44. MagnaIncome Trust 45. MerrillLynch PacificFund 46. MutualShares 47. NationalSecurities Stock Fund 48. NationalSecuritiesGrowthFund 49. NationalSecuritiesTotal ReturnFund 50. NationalSecuritiesIncome Fund 51. National SecuritiesPreferredFund 52. NationalSecurities BalancedFund 53. NationalSecurities Bond Fund 54. Newton Income Fund 55. Nicholas Income Fund 56. NortheastInvestors Trust 57. One WilliamStreet Fund Fund 58. Oppenheimer SecuritiesFund 59. Over-the-Counter 60. Penn SquareMutualFund Fund 61. Philadelphia 62. Pine Street Fund 63. PioneerFund 64. Price T. Rowe GrowthFund 65. PutnamGeorge Fund of Boston 66. PutnamGrowthFund Equities 67. PutnamInternational 68. Rowe Price Tax Free 69. Safeco Equity Fund 70. ScudderCommonStock Fund 71. ScudderIncome Fund Fund 72. ScudderInternational 73. SeligmanCommonStock Fund 74. SeligmanGrowthFund 75. SigmaInvestmentShares 76. SigmaTrust Shares 77. SovereignInvestors 78. SteadmanAssociated Fund 79. SteadmanInvestmentFund 80. Stein Roe and FarnhamStock Fund 81. Stein Roe Total ReturnFund 82. TempletonGrowthFund GrowthInvestors 83. Twentieth-Century 84. UnifiedMutualShares 85. United Services Gold Shares 86. Value Line Fund 87. Value Line Income Fund 88. Value Line Special SituationsFund 89. VanguardIndex Trust 90. Wall Street Fund 91. WashingtonMutualInvestors Fund 92. Wellesley Income Fund 93. WellingtonFund

Objective G, I G MCG G G I, S, G G MCG G, I G I I I, S I, S, G I, S I I I G, I MCG G G G, I G, I G, I G G, I, S G MCG I G, I G I, S G G, I G I G, I, S G, I I, G G, I G I, G G MCG G, I G, I G I MCG G, I G, I, S G, I I S, I, G

NOTE.-G = growth; I = income; MCG = maximum capital gain; S = stability.

This content downloaded on Wed, 9 Jan 2013 06:04:06 AM All use subject to JSTOR Terms and Conditions

278

Journal of Business

References
Admati,A. R.; Bhattacharya,S.; Pfleiderer,P.; and Ross, S. A. 1986. On timingand selectivity. Journal of Finance 41 (July):715-30. Admati,A. R., and Ross, S. A. 1985. Measuringinvestmentperformance in a rational model. Journal of Business 58 (January):1-26. expectationsequilibrium Bhattacharya, S., and Pfleiderer,P. 1983.A note on performance evaluation.Technical Report714. Stanford,Calif.: StanfordUniversity, GraduateSchool of Business. Black, F.; Jensen, M. C.; and Scholes, M. 1972.The capitalasset pricingmodel:Some empiricaltests. In M. C. Jensen (ed.), Studies in the Theory of Capital Markets. New York: Praeger. Blume, M. E., and Friend,I. 1973.A new look at the capitalasset pricingmodel.Journal of Finance 28 (March):19-33. Breen, W., Jagannathan, for heteroscedasticity in R., and Offer, A. R. 1986.Correcting tests for markettimingability.Journal of Business 59 (October):585-98. Chang, E. C., and Lewellen, W. G. 1984. Markettimingand mutualfund investment performance. Journal of Business 57 (January): 57-72. Connor, G., and Korajczyk,R. A. 1986. Performance with the arbitrage measurement pricing theory: A new frameworkfor analysis. Journal of Financial Economics 15 (March):374-94. Fama, E. F. 1972. Componentsof investment performance.Journal of Finance 27 (June):551-67. Grant, D. 1977. Portfolio performanceand the cost of timing decisions. Journal of Finance 32 (June):837-46. Henriksson, R. D. 1984. Market timing and mutualfund performance:An empirical investigation.Journal of Business 57 (January): 73-96. Henriksson,R. D., and Merton, R. C. 1981. On markettimingand investmentperformance II:Statisticalproceduresfor evaluatingforecastingskills. Journal of Business 54 (October):513-33. Jagannathan, R., and Korajczyk,R. A. 1986.Assessing the markettimingperformance of managedportfolios.Journal of Business 59 (April):217-35. of mutualfunds in the period 1945-1964.Journal Jensen, M. C. 1968.The performance of Finance 23 (May):389-416. Jensen, M. C. 1969.Risk, the pricingof capitalassets, and the evaluationof investment portfolios.Journal of Business 42 (April):167-247. Jensen, M. C. 1972.Optimalutilizationof marketforecastsand the evaluationof investment performance.In G. P. Szego and K. Shell (eds.), Mathematical Methods in Investment and Finance. Amsterdam: Elsevier. Kon, S. J. 1983.The markettimingperformance of mutualfund managers.Journal of Business (56) (July):323-47. Lehmann, B. N., and Modest, D. M. 1987. Mutualfund performanceevaluation:A comparison of benchmarksand benchmarkcomparisons. Journal of Finance 42 (June):233-65. Merton,R. C. 1980.On estimatingthe expected returnon the market.Journal of Financial Economics 8 (March):323-61. Merton, R. C. 1981. On markettimingand investmentperformance I: An equilibrium theory of value for marketforecasts. Journal of Business 54 (July):363-406. Sharpe, W. F., and Alexander,G. J. 1989. Fundamentals of Investments. Englewood Cliffs, N.J.: PrenticeHall. and multiplicaStevens, G. V. G. 1971.Two problemsin portfolioanalysis:Conditional tive randomvariables.Journal of Financial and Quantitative Analysis 6 (December): 1235-50. Treynor, J. L., and Black, F. 1973. How to use security analysis to improveportfolio selection. Journal of Business 46 (January): 66-86. Treynor,J. L., and Mazuy, K. K. 1966.Canmutualfundsoutguessthe market? Harvard Business Review 44 (July-August): 131-36.

This content downloaded on Wed, 9 Jan 2013 06:04:06 AM All use subject to JSTOR Terms and Conditions