Cliff Asness’s (AQR) View on Factor Timing

Cliff Asness (AQR Capital Management) on Factor Timing:

Authors: Asness

Title: The Siren Song of Factor Timing



Everyone seems to want to time factors. Often the first question after an initial discussion of factors is “ok, what’s the current outlook?” And the common answer, “the same as usual,” is often unsatisfying. There is powerful incentive to oversell timing ability. Factor investing is often done at fees in between active management and cap-weighted indexing and these fees have been falling over time. Factor timing has the potential of reintroducing a type of skill-based “active management” (as timing is generally thought of this way) back into the equation. I think that siren song should be resisted, even if that verdict is disappointing to some. At least when using the simple “value” of the factors themselves, I find such timing strategies to be very weak historically, and some tests of their long-term power to be exaggerated and/or inapplicable.

Notable quotations from the academic research paper:

"Finding a factor with high average returns is not the only way to make money. Another possibility is to “time” the factor. To own more of it when its conditional expected return is higher than normal, and less when lower than normal (even short it if its conditional expected return is negative). An extreme form of factor timing is to declare a previously useful factor now forever gone. For instance, if a factor worked in the past because it exploited inefficiencies and either those making the exploited error wised up or far too many try to exploit the error (factor crowding) one could imagine the good times are over and possibly not coming back. I think of these as the “supply and demand” for investor error!7 Factor efficacy could go away either because supply went away or demand became too great.

Why do I call factor timing a “siren song” in my title? Well, factor timing is very tempting and, unfortunately, very difficult to do well. Nary a presentation about factors, practitioner or academic, does not include some version of “can you time these?” or “is now a good time to invest in the factor?” I believe the accurate answer to the first question is “mostly no.” However, my answer is usually met with at least mild disappointment and even disbelief. Tempting indeed.

I argue that factor timing is highly analogous to timing the stock market. Stock market timing is difficult and should be done in very small doses, if at all. For instance, Asness, Ilmanen, and Maloney (2015) call market timing a “sin” and recommend, using basic value and trend indicators, to only “sin a little.” The decision of how much average passive stock market exposure to own is far more important than any plausibly reasonable amount of market timing. Given my belief in the main factors described above – that is I do not think they’re the result of data mining or will disappear in the future – the implication is to maintain passive exposures to them with small if any variance through time. Good factors and diversification easily, in my view, trump the potential of factor timing.

While I believe that aggressive factor timing is generally a bad idea, there is one possible exception. Perhaps the only thing of interest in these value spreads would be if and when we see things unprecedented in past experience. The 1999-2000 tech bubble episode focused on by AFKL was indeed such a time. If timing were ever to be useful it would be at such extremes. Factors being “arbitraged away” or an extreme version of “factor crowding” would likely entail observing such extremes. In the extreme crowding case we’d see spreads in the opposite direction of what value experienced in 1999-2000 when the value factor looked much cheaper than any time in history. So, an “arbitraging away” would lead to a factor looking much more expensive than any time in history. To date, the evidence that this has already occurred is weak and mixed. For example, if you look at the “value spread” of the factors through time to judge them as cheap or expensive, you get very different answers depending on whether you use, say, book-to-price or sales-to-price. For instance, if you use book-to-price you’d find the value factors currently look cheap versus history (though nowhere near the levels of 1999-2000) and the non-value factors (things like momentum, profitability, low beta) look expensive. However, if instead you use sales-to-price to make this judgment you find current levels are far closer to historical norms.

In sum, here’s what I would suggest. Focus most on what factors you believe in over the very long haul based on both evidence (particularly out-of-sample evidence including that in other asset classes) and economic theory. Diversify across these factors and harvest/access them cost-effectively. Realize that these factors, like the stock market itself, are now well-known and will likely “crash” at some point again. So, invest in them if you believe in them for the long-term and be prepared to survive, not miraculously time, these events sticking with your long term plan. If you time the factors, and I don’t rule it out completely, make sure you only “sin a little.” Continue to monitor such things as the value spreads for signs these strategies have been arbitraged away – like value spreads across a diversified set of value measures being much less attractive and outside the historical reasonable range – signs that, as of now, really don’t exist."

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