The Retired Fund is an open-ended mutual fund composed of $500 million in U.S. bonds and U.S. Treasury bills. This fund has had a portfolio duration (including T-bills) of between 3 and 9 years. Retired has shown first-quartile performance over the past 5 years, as measured by an independent fixed-income measurement service. However, the directors of the fund would like to measure the market timing skill of the fund’s sole bond investor manager. An external consulting firm has suggested the following three methods:
a. Method I examines the value of the bond portfolio at the beginning of every year, then calculates the return that would have been achieved had that same portfolio been held throughout the year. This return would then be compared with the return actually obtained by the fund.
b. Method II calculates the average weighting of the portfolio in bonds and T-bills for each year. Instead of using the actual bond portfolio, the return on a long-bond market index and T-bill index would be used. For example, if the portfolio on average was 65% in bonds and 35% in T- bills, the annual return on a portfolio invested 65% in a long-bond index and 35% in T-bills would be calculated. This return is compared with the annual return that would have been generated using the indexes and the manager’s actual bond/T-bill weighting for each quarter of the year.
c. Method III examines the net bond purchase activity (market value of purchases less sales) for each quarter of the year. If net purchases were positive (negative) in any quarter, the performance of the bonds would be evaluated until the net purchase activity became negative (positive). Positive (negative) net purchases would be viewed as a bullish (bearish) view taken by the manager. The correctness of this view would be measured.
Critique each method with regard to market timing measurement problems.