Ideas with Impact
UNB Faculty of Management

In the investment world, the ability to forecast cash flows and earnings has long been considered a cornerstone of successful securities evaluation. A new study by UNB finance professor, Dr. Chunhua Lan, sheds light on the under-appreciated importance of market timing in managing mutual funds. Her paper, “The efficacy of market timing and value creation,” has been accepted by the Journal of Financial Research, an A-rated journal on the ABDC list.

According to the study, some actively managed US mutual funds have demonstrated impressive timing skills, which has led to notable value creation for their investors.

Dr. Lan’s research applies a key concept - "value-added"- which measures the value a mutual fund adds to its portfolio by multiplying its abnormal returns by its size. Her findings reveal that the top 20% of actively managed US mutual funds collectively add $3.4 billion per year in constant January 2000 dollars—an impressive figure that demonstrates the real-world impact of market timing on asset management.

Prior studies suggested that mutual fund managers typically fail to time the stock market. However, Dr. Lan’s approach breaks new ground by differentiating between two types of timing strategies: cash flow timing and discount-rate (expected return) timing. Her study emphasizes the superior importance of cash flow timing for mutual fund managers seeking to create value.

Cash flow timing refers to a manager's ability to anticipate and react to changes in aggregate cash flows, positioning their portfolio to capitalize on these fluctuations. Dr. Lan explains that the most skilled fund managers achieve this by combining sector rotation and individual stock selection.

With sector rotation, managers shift their portfolio allocation to cyclical sectors when they expect positive cash flow changes and move to defensive sectors when anticipating downturns. With stock selection, they select stocks with high cash flow sensitivity during periods of high aggregate cash flows and opt for stocks with low sensitivity when cash flows are expected to be low.

These strategic tilts allow managers to adapt quickly to economic shifts, leveraging timing skills to enhance returns and create significant value for their investors.

Previous studies assess a manager's skill based on fund alpha, which measures performance relative to a benchmark. Instead, Dr. Lan’s research suggests that a fund's success depends not just on generating abnormal returns but also on the scalability of its strategy. This shift in thinking has the potential to change how both fund managers and investors evaluate performance. As demonstrated in Dr. Lan’s paper, a strategy capable of effectively timing aggregate cash flows is valuable from both perspectives.

As Dr. Lan notes, “It provides strong evidence of market-timing skills through cash flow timing, challenging the conclusions of previous literature.”

Understanding how mutual funds with strong skills in timing cash flows can create substantial value can help investors and fund managers refine their strategies by focusing on cash flow timing rather than just market timing or discount-rate timing. If mutual funds are better at creating value through improved timing strategies, it could lead to better investment outcomes for individuals saving for retirement or other financial goals. Additionally, increased understanding of fund performance can lead to more informed investment decisions by the general public.

Dr. Chunhua Lan teaches finance courses in the Master of Quantitative Investment Management (MQIM) program, as well as in the BBA and MBA. Her research interests span investments, mutual funds, asset pricing models, portfolio choices, and institutional investors' impact on financial markets.

Her recent study is a vital contribution to the mutual fund management field. It underscores the importance of focusing on cash flow timing as a core driver of value creation, reshaping the way we think about the skills required to manage mutual funds successfully.

Photo: New research by UNB finance professor, Dr. Chunhua Lan sheds light on the under-appreciated importance of market timing in managing mutual funds.

Learn more about Dr. Chunhua Lan and UNB’s Faculty of Management.

Media contact: Liz Lemon-Mitchell.