Ferri: Market Timing Best Avoided

I’m always interested in reading academic studies that measure how well professional mutual fund managers can time financial markets. Many fund companies routinely claim their experienced management and propriety research give them a leg up on knowing where the markets are headed next. But is it true? Have mutual fund managers made profitable timing decisions ahead of the markets’ next movements?

The past 15 years has been an ideal time to test timing skill given two significant stock market downturns: the technology bust of 2000 and the financial crisis of 2008. Both periods were characterized by a sharp downturn in equity prices, rallies in government bonds, and widening spreads on corporate debt.

You’d think professional fund managers would have a good sense of market direction since 2000 and be able to take advantage of dramatic market trends. Yet, a new study on fund manager market-timing skill finds it’s remained lacking since the new millennium.

In their paper, Multi-asset class mutual funds: Can they time the market? Evidence from the US, UK and Canada, Andrew Clare, Niall O’Sullivan, Meadhbh Sherman and Stephen Thomas, offer little evidence to support a view that fund managers have been able to add value through market timing. “Our results indicate overall that timing skill is rare,” the researchers conclude, “and is found among a small minority of funds.”

Using fund data obtained from Morningstar, the authors analyzed 617 multi-asset class mutual funds in the US, UK and Canadian markets from 2000 through 2012. Monthly returns and monthly asset class weights were used in the study. Note that only surviving fund returns were measured; funds that closed were not included.

Two methods were used to calculate market-timing skill in the study. The returns-based approach compared each fund’s long-term strategic asset allocation objective to its short-term tactical weight, and measured the benefit of the timing decisions. Value was added (lost) when a tactical shift increased (decreased) total return above (below) the strategic mix.

Figure 1 illustrates the results of the returns-based approach. The blue bar (top) represents the percentage of fund managers who added value using market timing at a 5% significance level, and the red bar (bottom) represents the percentage taking away value at a 5% significance level.

Figure 1: Percentage of Managers Adding (Losing) Value Due to Market Timing (5% Significance)

Source: "Multi-asset-class mutual funds: Can they time the market? Evidence from the US, UK and Canada"

A second approach analyzes individual holdings across asset classes and measures the alpha (or lack thereof) generated (or not) by these individual investment decisions. The holdings-based approach is more precise because the timing in each asset class is measured.

Here, the authors reported: “We see evidence of statistically significant positive equity market timing among 13.6% of Canadian funds and 6.4% of US funds but not among UK funds. There is also some evidence of government bond market timing among UK funds (10.5%) and US funds (9.3%) though less so among Canadian funds (5.4%) while across the three regions there is generally less evidence of corporate bond market timing ability.”

Recall that only surviving fund performance was measured, so any outperformance should be taken with a grain of salt; the numbers would likely have been lower had non-surviving funds’ performances been included.

Overall, the study concludes that there is little evidence that managers of funds that survived the entire period had positive timing skill in the US multi-asset class fund industry. The same is true in the UK fund industry. Canada exhibited a higher level of market-timing skill during the period tested.

I am interested in these sorts of studies because they show how difficult market timing is even for professional fund managers with access to far more information than individual investors and advisers enjoy. It’s hard to imagine individuals or advisers experiencing better results with fewer resources available, which leads me to conclude that market timing remains a strategy best avoided.

For a full list of relevant disclosures, click here. Rick Ferri, founder of Michigan-based Portfolio Solutions, is a widely recognized index investor and the author of several books on index investing.