There is perhaps no issue that is the subject of more debate in the factor investing community than factor timing. We are all trained to buy low and sell high, and it is tempting to conclude that we can do the same thing with factors. For example, if value stocks have struggled for a long period of time and they are cheap relative to their history, it makes intuitive sense to add exposure to them and to try to take advantage of mean reversion when they bounce back. It also makes sense in theory to reduce exposure to a factor after a long run of positive relative performance. As is the case with many things in investing, though, the actual implementation of that concept proves much more difficult in the real world than it seems in theory.
This is a very difficult topic to write about because there really is no right answer. Whenever Rob Arnott of Research Affiliates and Cliff Asness of AQR, two widely followed and hugely successful investors in the field of quantitative investing, disagree on a topic, as they do on this one, you can safely assume it is very complex and that the answer is not clear.
In his 2016 paper “Timing “Smart Beta” Strategies? Of Course! Buy Low, Sell High!” , Arnott looked at factor timing using both the best and worst performing factors and compared the result to a portfolio that is equal weighted across all the factors. The trend-chasing and contrarian portfolios he built each held the top 3 factors that either performed best or worst using an average of four historical periods. The equal weighted portfolio held an equal exposure to all eight factors they follow. As you would probably expect, the strategy of chasing the hot factor did not work. But the contrarian strategy of buying the out of favor factor did produce more alpha than the equally weighted approach, but that result did come with higher risk due to less factor diversification, so the risk adjusted return was lower than the equally weighted portfolio. This result offers evidence that factor timing is possible, but also supports the thesis that it is very difficult to do in practice.
Cliff Asness countered that paper with one of his own titled “Contrarian Factor Timing is Deceptively Difficult”. He summarized the paper in a separate post this way:
In our latest paper, we again show that factor timing is likely even harder than market timing. First, the long-short factors in question have higher turnover than the market, making long-run predictability, the possible savior of market timing, a much dodgier proposition for factor timing. Second, unlike timing the market, timing factors using just valuation must contend with contrarian factor timing being already implicitly (but strongly) present in the value factor itself. Despite the rhetoric calling factor timing simple common sense, it isn’t at all obvious that one should value-time factors, at least not to any significant extent (and if one is saying to do just a tiny bit, then let’s not argue about the insignificant!), and certainly not while they’re currently within historical bounds as they are today.
So what should an average investor do when two of the best minds in factor investing disagree on a topic? I think the best thing to do is probably to steer clear of it. If the best investors can’t agree on if something works, the odds of a regular investor successfully implementing it in their portfolio are very low. Having said that, I do tend to agree with Rob Arnott that when done properly, factor timing can enhance returns in a portfolio. For those who do try to implement factor timing, I think there are a few rules of thumb that can help.