Optimal allocation of government bond funds through the business cycle. Is money smart?

- Optimal allocation to US government bond funds is higher when the business cycle deteriorates and bond risk premia rise.
- US government bond fund managers add value to the investors when most needed.
- Good US government bond fund performance during recession and search costs justify the lack of smart money effect evidence.

We characterize the optimal portfolio decision of an investor who maximizes the conditional expected utility of the return on his or her portfolio, given an investment opportunity set consisting of a U.S. sovereign bond mutual fund and its benchmark. Our results show that, on average, the investor should overweight U.S. government bond funds during recession periods when the “level” factor of interest and the output gap are low and the “curvature” factor of the U.S. yield curve, investor sentiment and the VIX are high, these being related to high U.S. bond risk premia. Important differences in optimal portfolio performance measures across bond fund managers through the business cycle have a great impact on the investor's welfare. However, we find almost no evidence that funds that receive more money subsequently beat the market.