The relative share of academic work on bond funds is dwarfed by the share and importance of these funds and assets in the economy. Elton, Gruber and Blake (1993, 1995) and Ferson, Henry and Kisgen (2006) study US bond mutual fund performance, concentrating on the funds' risk-adjusted returns, or alphas. These studies find that the typical average performance after costs is negative and on the same order of magnitude as the funds expenses. However, the total performance may be decomposed into components, such as timing and selectivity ability.
If investors place value on timing ability, for example a fund that can mitigate losses in down markets, they may accept a total performance cost for this service. To better understand performance we need to examine its components. We argue that a logical place to start, in the case of fixed income funds, is to study timing ability. That is the goal of this paper. This is one of the first papers to comprehensively study the ability of US bond funds to time their markets.
Timing ability on the part of a fund manager is the ability to use information about the future realizations of common factors affecting security returns. Selectivity refers to the use of security specific information. If common market factors explain a relatively large part of the variance of a typical bond return, it follows that a relatively large fraction of the potential performance of bond funds is likely attributed to timing. Thus, a logical step in looking at performance is to concentrate on timing ability. However, measuring the timing ability of fixed income funds is a subtle problem.
Traditional models of market timing ability rely on convexity in the relation between the fund's returns and the common factors. In bond funds, perhaps even more clearly than in equity funds, convexity or concavity can arise for various reasons unrelated to timing ability. Our empirical analysis controls for other sources of nonlinearity. These include convexity or concavity that may be inherent in the benchmark assets held by a fund, the use of dynamic trading strategies or derivatives, portfolios that respond to publicly available information and stale prices in the measured returns.
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Measuring the Timing Ability of Fixed Income Mutual Funds
