Correcting for Heteroscedasticity in Tests for Market Timing Ability

Evaluating the performance of portfolio managers has received wide attention in the finance literature. The common practice is to divide performance into (a) market timing ability and (b) security selection ability. The former is the ability of a fund manager to produce a better return distribution by forecasting marketwide movements. The latter is the ability to produce more favorable return distributions based on superior information about individual stocks. Several methods have been proposed in the literature for the evaluation of the selection and the timing abilities of portfolio managers, using only the observed time series of realized returns on the managed portfolios. Among the approaches proposed, the multiple regression approach suggested by Treynor and Mazuy (1966), Henriksson and Merton (1981), and Pfleiderer and Bhattacharya (1983) are particularly attractive since they are simple and easy to apply. While the above multiple regression methods are easy to apply, statistical inference requires care. 1 In this paper we examine the parametric test proposed by Henriksson and Merton for evaluating the market timing ability of portfolio managers. Using simulation techniques we show that correction for heteroscedasticity can significantly affect the conclusions. We find that the heteroscedasticity corrections suggested by Hansen and by White are particularly effective.