Following a series of posts discussing factor investing with a focus on premiums derived from exposures to the value, quality, momentum and low-risk factors in equity markets, we now focus on the issue of factor timing, i.e. the idea that individuals are capable of forecasting when a given factor premium may turn negative. Factor timing is a tempting concept: it is easy to see that some factors perform much better under certain types of market regime. So, being able to pick the right factor at the right time would potentially be very advantageous. In this article I’ll go through the reasons behind our view that this notion is a fallacy and explain why it makes more sense to diversify and be persistent.
Understanding factor timing through market cycles
Market cycles are the best way to understand the attraction of factor timing: when a bubble forms in the market, momentum is at its best: trendy stocks outperform, irrespective of their valuation or profitability, as more and more investors accept the idea that ‘this time it’s different’ and climb on the bandwagon, thus inflating the bubble (often initiated by a disruptive innovation).
When investors start to question the importance of valuations, set up innovative valuation measures, or question the sheer existence of the value premium, these are usually good signs that ‘market exuberance’, as Alan Greenspan once named it, is peaking.
When, subsequently, the bubble bursts, it is risk that becomes the main subject with the low-volatility and value factors outperforming. And when investors wonder what to buy next it is the quality factor that comes back. The cycle of bubbles and crises is very apparent to anyone following events in the markets. Another way to look at it is to remind ourselves that some factors, despite offering, on average, offered attractive premiums in the past, sometimes underperformed for years in a row. So why not tactically change the allocation to factors, just as we allocate tactically across asset classes?
In fact, there is one approach that works not only across asset classes but also across factors: target volatility. We have published our analysis of such strategies in two papers, one dedicated to their application to asset classes, “Predicting the success of volatility targeting strategies: Application to equities and other asset classes”, which appeared in the Journal of Alternative Investments in January 2016, and one dedicated to their application to factor investing, “Inter-Temporal Risk Parity: A Constant Volatility Framework for Factor Investing” which appeared in the Journal of Investment Strategies in December 2014.
Within a target volatility framework, the risk budget allocation to asset classes or factors is kept constant over time. Consequently, the allocation in weight to an asset class will fall when the volatility of the asset class increases and will rise when the volatility falls. For factors, it is either the active share (in the case of a long-only portfolio) or the leverage (for long-short portfolios) required to generate the exposure to a factor such as value or momentum that will increase when the volatility of the factor decreases and will increase when the volatility decreases.
Target volatility strategies generate just moderate tactical changes in the allocation of a weighting to a particular asset class, factor active share or factor leverage. They do not generate negative exposures to either asset classes or factors. In that sense the tactical allocation resulting from target volatility strategies is indeed moderate.
Does factor timing generate additional returns?
Can we be more aggressive when it comes to factor timing, completely removing the exposure to a factor from the portfolio at a given point in time? Or even more radically, reversing exposure from positive to negative, e.g. move from preferring cheap stocks to preferring expensive stocks? This question is by no means settled from an academic point of view. Our research, so far, seems to corroborate the views of Cliff Asness summarised in a recent editorial comment in The Journal or Portfolio Management: strong evidence that aggressive factor timing can generate additional returns is still lacking.
Investors should thus focus on factors that are expected to generate a premium over the long-term, such as value, quality, momentum and low volatility, allocating the same risk budget to each of this factor in order to increase diversification. Put simply, that means employing all the factors, and without changing their risk budget allocation over time. Ultimately, this comes down to relying on diversification and persistence. By doing so, the active share or leverage allocated to a factor will change moderately over time in the opposite direction to the factor’s volatility. This mild form of factor timing does generate additional excess returns as demonstrated and posited in our research papers.
Please note that this article may contain technical language. For this reason, it is not recommended to readers without professional investment experience.