Key Points

  • We analyze three factor-timing strategies and find that a strategy based on a factor’s discount (or valuation) and momentum is the most effective tool for determining how to vary a factor’s exposure through time.

  • We find that the economic stage six months ahead influences factor returns. Accurately predicting what that stage will be is difficult, however, given current economic forecasting tools.

  • Until economic-prediction models can be improved, we find that information gained by estimating the economic stages is already incorporated in a factor’s discount and momentum.

Readers of “Factor Returns’ Relationship with the Economy? It’s Complicated” (Aked, 2020) learned that some degree of variability in a factor’s return across the business cycle exists. Therefore, the ability to add additional sources of return by adding exposure to more than one factor should be of great interest to investors who seek more consistency in shorter-term results.1 Here, I extend the research of Aked (2020) to help investors better understand how they can vary their factor exposures through factor timing to potentially gain more profitable and more dependable investment results.

Factor timing is the ability to add value to an investment strategy by altering the exposure to various factors through time. I evaluate three factor-timing strategies using 1) a factor’s historical return, 2) the economic stage, and 3) a factor’s discount and momentum. In each case, the strategy is constructed out of sample, using data only available at the time of the specific sample period.

We find that the third strategy, employing a factor’s discount and momentum, is the most effective tool for determining how to vary a factor’s exposure through time. Although a factor’s return changes throughout the business cycle, the ability to predict economic regimes and alter factor allocations accordingly produces less successful results despite being intuitively pleasing. We find that the first strategy, using a factor’s historical performance as a guide to the future, is nearly worthless. Therefore, whereas keeping track of the economy is an important part of the overall investment process, the most important element in factor investing strategies is maintaining a close link to a factor’s discount and momentum.

We examine the same eight primary factors as Aked (2020) (market, value, investment, size, illiquidity, profitability, low beta, and momentum) across the same six regions of Australia, United States, Europe, United Kingdom, Japan, and the emerging markets.2 Appendix A provides the factor definitions and their returns over the four economic stages.

We construct a small and a large portfolio for each factor, with the exception of market and size. This process yields 14 separate factor portfolios. Because the United States has the longest history, the first month of our analysis period (June 1969) includes only US data. We rank each portfolio by its expected return, and place the highest four in Quartile 4 and the lowest four in Quartile 1, repeating the exercise for the next month, and so on.