Risk Factor and Liquidity Timing: A Short-Term Approach

Abstract

This paper outlines a comprehensive timing approach starting from a conditional model in order to examine daily as well as monthly risk factor timing. Moreover, timing of liquidity risk is explored as evidence on this issue is still missing in the timing literature. The Kalman filter approach considered in this paper introduces time-variation in risk exposures, without having to rely on instrument variables which are often unavailable at a daily frequency. Then, timing, conditioning and forecasting abilities of fund managers are simultaneously analyzed regarding a broad set of mutual funds as well as hedge funds. The 2002 to 2009 period considered covers the recent financial market crisis. The findings suggest that there are no daily risk factor timing abilities by the asset managers examined, but that non-plausible evidence of perverse market timing is reduced by moving from unconditional timing tests to a dynamic timing approach. In contrast to the more promising evidence on monthly risk factor timing for mutual and hedge funds, fund managers either do not appropriately react to daily factor information or form false expectations about risk factor performance. Evidence on liquidity timing, whose importance as a risk factor has been emphasized in recent research, is negligibly weak. This also holds for the still novel idiosyncratic risk factor and the widely used Carhart factors. Overall, awareness of fund managers has to be directed to more actively manage dynamics in undiversifiable risk factors.

Keywords: conditional multifactor model, risk factor timing, liquidity, idiosyncratic risk, mutual funds, hedge funds, Kalman filter

JEL Classification: G11, G12