Market Timing Ability of Hedge Funds

Abstract

The purpose of the study is to examine whether market timing ability explains the returns of hedge funds. Market timing ability is simply adjusting fund’s market exposure according to market conditions. Market timing is an extensively studied area among mutual funds, but only little evidence of timing ability is found. Hedge funds, however, serve as an attractive field to investigate the timing ability since they are found to have abnormal performance, and in most cases, they outperform mutual funds. This outperformance is considered as a result from their unique characteristics compared to mutual funds.

Hedge funds are less restricted which allow them to use more freely different instruments, such as derivatives, short selling and leverage, leading them to use more dynamic trading strategies. Thus, if market timing ability exists it is more likely to capture such a skill among hedge funds. So far, only few studies concern hedge funds and the results are rather mixed. Moreover, these studies mostly cover time period around 2000 or the financial crisis of 2008, hence, there is a need for more recent study.

This study examines 159 equity-oriented hedge funds during the 2004 – 2017 period. Two main groups are separated according to their geographical focus markets, namely the US hedge funds and emerging markets hedge funds. Five different models are examined in order to discover whether the choice of model affects the results. The focus is on the cross-sectional returns of hedge funds and by using Fama MacBeth (1973) regressions the market timing is detected across the sample.

The results show that hedge funds show significant selectivity ability over their focus market. However, no evidence is found that hedge funds can time their focus market and it stays the same across models. Moreover, the results from the eight-factor model indicate that funds of hedge funds can time their focus market. Overall, the results imply that hedge funds’ returns are not fully captured by the traditional models and that, multi-factor models are needed when examining the performance of hedge funds.