Learning outcomes.
After watching this video,
you will be able to;
one, understand market timing.
Well, the next thing I want to talk about here is market timing.
So remember that there are two components to a fund manager's performance.
In fact, if you go and ask
an actively managed fund manager and ask him how do you make money,
most likely he'll come up with one or two - method one or method two or both.
Method one is I'm smarter,
so I'm going to pick securities better than the next guy.
In other words, I will select stocks
better than the next guy and that's how I make my money.
That's called security selection.
On the other hand,
there is an aspect of making money which is called market timing.
In other words, suppose they say I am very good at timing the market.
What does that mean? It means that I know that
stock markets are going to underperform next year;
I'm able to prognosticate.
So what I will do is before the beginning of the year,
I'm going to move from stocks to bonds.
And if I know that stock market is going to perform better,
I'm going to move into stocks at that time.
So this ability to move in and out of
the market at the right time is not surprisingly called timing.
But if you look at this figure,
what you will see is suppose you draw a graph of
a managed portfolio or a fund-managed fund manager return on the y axis,
the vertical axis and the return on the market or some benchmark on the x axis.
You will notice that this manager has absolutely zero alpha - that's the two lines
meeting at the origin - and you will see that when the market is expected to be high,
he moves into a high beta portfolio,
which makes a lot of sense because a high beta portfolio stands to
gain much more when the market itself is doing well.
And when the market is forced to do not so well,
that is a low state,
he moves into a low beta portfolio,
thereby limiting his exposure to the market.
However, what I will observe is points
A and B. I don't observe the two lines as an analyst.
And when I observe the two lines - sorry,
the two points A and B and connect the line through them,
I get the dashed line.
And the dashed line concludes two wrong things; number one,
it tells me that because it has a negative intercept,
the fund manager has a negative alpha.
Wrong conclusion number one.
Number two, since the slope of the dashed line is larger than either of the solid lines,
you would also falsely accuse this person of having greater,
at least systematic, risk compared to what he had in either state.
Bottom line, if you look at measures like alpha,
they do not measure timing ability sensibly.
We need better ways to try and measure
whether managers can time markets in any sensible way.
And that's where we're going to go next.