Factor Timing Is Tempting

Academic research has found that factor premiums are both time-varying and dependent on the economic cycle. For example, Arnav Sheth, and Tee Lim, authors of the December 2017 study “Fama-French Factors and Business Cycles,” examined the behavior of six Fama-French factors—market beta (MKT), size (SMB), value (HML), momentum (MOM), investment (CMA) and profitability (RMW)—across business cycles, splitting them into four separate stages: recession, early-stage recovery, late-stage recovery, and very late-stage recovery. Their data, including the results shown in the following table, covered the period April 1953 through September 2015.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.

As you can see, factor premiums vary and are regime-dependent. That, of course, makes timing them tempting. However, in their study “Contrarian Factor Timing Is Deceptively Difficult,” which appeared in the 2017 special issue of The Journal of Portfolio Management, Cliff Asness, Swati Chandra, Antti Ilmanen, and Ronen Israel found “lackluster results” when they investigated the impact of value timing—whether dynamic allocations can improve the performance of a diversified multi-style portfolio. They found that “strategic diversification turns out to be a tough benchmark to beat.” They added: “Tactical value timing can reduce diversification and detract from the performance of a multi-style strategy that already includes value.” They also found that contrarian value timing of factors, while tempting, is generally a weak addition for long-term investors holding well-diversified factors including value, and specifically, it does not send a strong signal even when valuations are stretched.

Providing further evidence of the difficulty of timing factor premiums is the August 2018 study “Factor Exposure Variation and Mutual Fund Performance.” The authors, Manuel Ammann, Sebastian Fischer, and Florian Weigert, examined whether actively managed mutual funds were successful at timing factor premiums (net of fees) over the period late 2000 through 2016. They found that while factor-timing activity is persistent, risk factor timing is associated with future fund underperformance. For example, a portfolio of the 20 percent of funds with the highest timing indicator underperformed a portfolio of the 20 percent of funds with the lowest timing indicator by a risk-adjusted 134 basis points per year with statistical significance at the 1 percent confidence level (t-stat: 3.3). Summarizing their results, Ammann, Fischer, and Weigert concluded:

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Disclaimer: Performance figures contained herein are hypothetical, unaudited and prepared by Alpha Architect, LLC; hypothetical results are intended for illustrative purposes only. Past ...

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