Question

You have collected 6 years of monthly data on return of funds ABC and XYZ as well as on S&P/TSX composite index and the government short term bills (risk-free). You have run two (excess return) index-model regressions for the two bonds and the results are as follows:

For ABC, rp – rf = 0.01 + 1.4(rM – rf) + 2.2(rM – rf)2 R2=0.96

For XYZ, rp – rf = 0.02 + 2(rM – rf) - 3.2(rM – rf)2 R2=0.80

a) Which manager shows a better ability to time the market? Why?

Answer 1

Whenever we do a regression of excess returns of a fund with excess return of benchmark (composite index) as an independent variable, the constant term in the regression represents alpha.

Alpha is the excess return a fund manager generates over the benchmark index. The higher the value of alpha, the better the performance of the fund manager, hence better the ability of the manager to time the market.

Alpha for fund ABC is equal to 0.01 or 1%

Alpha for fund XYZ is equal to 0.02 or 2%

Since, alpha for fund XYZ is higher, its fund manager has better timed the market.