Dynamic Performance Evaluation of Canadian Fixed-Income Funds using Markov Regime Switching Models

Abstract

This thesis examines the performance of Canadian fixed-income mutual funds in the context of an unobservable market factor that affects mutual fund returns. We use various selection and timing models augmented with univariate and multivariate regime-switching structures. These models assume a joint distribution of an unobservable latent variable and fund returns. The fund sample comprises six Canadian value-weighted portfolios with different investing objectives from 1980 to 2011. These are the Canadian fixed-income funds, the Canadian inflation protected fixed-income funds, the Canadian long-term fixed-income funds, the Canadian money market funds, the Canadian short-term fixed-income funds and the high yield fixed-income funds. We find strong evidence that more than one state variable is necessary to explain the dynamics of the returns on Canadian fixed-income funds. For instance, Canadian fixed-income funds clearly show that there are two regimes that can be identified with a turning point during the mid-eighties. This structural break corresponds to an increase in the Canadian bond index from its low values in the early 1980s to its current high values. Other fixed-income funds results show latent state variables that mimic the behaviour of the general economic activity. Generally, we report that Canadian bond fund alphas are negative. In other words, fund managers do not add value through their selection abilities. We find evidence that Canadian fixed-income fund portfolio managers are successful market timers who shift portfolio weights between risky and riskless financial assets according to expected market conditions. Conversely, Canadian inflation protected funds, Canadian long-term fixed-income funds and Canadian money market funds have no market timing ability. We conclude that these managers generally do not have positive performance by actively managing their portfolios. We also report that the Canadian fixed-income fund portfolios perform asymmetrically under different economic regimes. In particular, these portfolio managers demonstrate poorer selection skills during recessions. Finally, we demonstrate that the multivariate regime-switching model is superior to univariate models given the dynamic market conditions and the correlation between fund portfolios.