Performance Measurement with Market and Volatility Timing and Selectivity

To measure the investment performance of a portfolio manager who may engage in market timing, it is necessary to consider both market level and volatility timing behavior as well as security selection ability. We develop and implement measures that accommodate all three components. A well specified measure of performance is the sum of the three components of ability. Estimating the measures on active US mutual funds, we find that allowing for market level and volatility timing, there is no evidence of investment ability at the level of broad groups of mutual funds, or when funds are sorted by expense ratio, return gap, active share or turnover. However, sorting by factor model R-squares confirms results in Amihud and Goyenko (2011), where the low R-square funds have better performance. * Ferson is the Ivadelle and Theodore Johnson Chair of Banking and Finance and a Research Associate of the National Bureau of Economic Research, Marshall School of Business, University of Southern California, 3670 Trousdale Parkway Suite 308, Los Angeles, CA. 90089-0804, ph. (213) 740-5615, [email protected], wwwrcf.usc.edu/~ferson/. Mo is a Ph.D student in Finance, Marshall School of Business, University of Southern California, [email protected]. We are grateful to Fabio Moneta for help with some data, to participants at the 2012 Sonoran Finance Conference for helpful discussions, and to our discussant Oliver Boguth. Performance Measurement with Market and Volatility Timing and Selectivity PRELIMINARY February 26, 2012 ABSTRACT: To measure the investment performance of a portfolio manager who may engage in market timing, it is necessary to consider both market level and volatility timing behavior as well as security selection ability. We develop and implement measures that accommodate all three components. A well specified measure of performance is the sum of the three components of ability. Estimating the measures on active US mutual funds we find that, allowing for market level and volatility timing, there is no evidence of investment ability at the level of broad groups of mutual funds, or when funds are sorted by expense ratio, return gap, active share or turnover. However, sorting by factor model R-squares confirms results in Amihud and Goyenko (2011), where the low Rsquare funds have better performance. To measure the investment performance of a portfolio manager who may engage in market timing, it is necessary to consider both market level and volatility timing behavior as well as security selection ability. We develop and implement measures that accommodate all three components. A well specified measure of performance is the sum of the three components of ability. Estimating the measures on active US mutual funds we find that, allowing for market level and volatility timing, there is no evidence of investment ability at the level of broad groups of mutual funds, or when funds are sorted by expense ratio, return gap, active share or turnover. However, sorting by factor model R-squares confirms results in Amihud and Goyenko (2011), where the low Rsquare funds have better performance.