The Dynamics of Mutual Funds and Market Timing Measurement

Nonlinearity in the relationship between mutual funds and market returns is often assumed when market timing is assessed. Hence, a quadratic term is introduced into the classic linear model to measure market timing. However, nonlinearity could be due to other factors and the evidence of market timing, usually negative in the literature, may therefore be biased. In this context, the aim of this paper is to analyze the effect of time-varying beta risk and benchmark omission when measuring market timing ability in mutual funds. The first part of the paper shows how the existence of time-varying beta risk produces artificial evidence of market timing, especially when considering asymmetries. In the second part, Kalman filtering is used to estimate the time-varying beta for mutual funds and market timing is then assessed. In general, changes in risk are not related to up and down markets, although some funds show a negative relation between beta variation and market sign. Evidence of negative market timing may be inferred from this result. The results are sensitive to two outliers, corresponding to the launch of the Euro in European financial markets and 9-11. However, passive benchmarks with asset weights different from those of the benchmark also give rise to this result. After these omitted benchmarks have been introduced, any previous evidence of negative market timing disappears almost completely. These results hold when mutual fund net cash flows are controlled for. Therefore, time-varying beta risk and benchmark omission could produce a spurious relationship between the variation of portfolio risk and markets which, in the absence of information about timing decisions, could lead us to infer evidence of market timing mistakenly.