A Non-Parametric Test of Market Timing for Hedge Funds: Beyond Alpha and Beta

We propose a new test of market timing, based on the randomisation of the dynamic risk structures of hedge funds. This test enables us to assess the capacity of managers to time the market (positive market timing) or to assess the costs inherent to some negative externalities, such as the exposure to liquidity risk, sensitivity to risk aversion or the mismanagement of leverage (negative market timing). By applying this test to more than 6,700 individual hedge funds, we show that the performance attribution of various investment styles cannot be restricted to the two usual components, i.e. alpha and beta. Our results show that market timing is a major performance driver for Managed Futures, CTAs and certain Global Macro funds. Conversely, leverage needed to capture alpha and increased risk aversion sensitivity in relative value and arbitrage strategies induces a cost in terms of performance, formalised by negative market timing. We also show that within the different hedge fund styles, good market timers tend to deliver lower alpha.