Timing “Smart Beta” Strategies? Of Course! Buy Low, Sell High! by Rob Arnott, Noah Beck & Vitali Kalesnik – Research Affiliates

Key Points

  • A contrarian timing approach—emphasizing factors or strategies trading cheap relative to their own historical norms, and deemphasizing the more expensive factors or strategies—can improve performance, but should be used in moderation to avoid increasing portfolio risk from a loss of diversification.
  • Contrarian timing is a form of value investing, but is not the same as doubling down on value risk. Relative valuation may support investing in the value factor when value is cheaply priced, and conversely, may indicate avoiding the value factor when it is expensive.
  • Most investors already practice a form of market “timing” by performance chasing, which can erode the benefits of factor investing even when diversifying across factors having recent strong results.
  • Valuations matter. Smart beta strategies and factors trading at a discount to their historical norms are poised to deliver positive performance in the crowded smart beta investing space.

This is the third of a series on the future of smart beta.

In the first article—“How Can ‘Smart Beta’ Go Horribly Wrong?”—we show that performance chasing can be as dangerous in smart beta as it is in stock selection, fund selection, or asset allocation. We differentiate between “revaluation alpha” and “structural alpha.” The former is the part of the past return that came from rising valuations.1 Revaluation alpha is nonrecurring, and is at least as likely to reverse as to persist. Rising valuations create an illusion of alpha and encourage performance chasing.

Structural alpha is the part of the past return that was delivered net of any impact from rising valuations. Why do we emphasize rising valuations? Because factors and strategies with tumbling valuations are rarely noticed in the data mining so pervasive throughout the finance community.2 For some factors, such as low beta, we show that most or all past performance was revaluation alpha, which could easily reverse from current valuation levels. For smart beta strategies, the picture is a bit better: most established products have respectable structural alpha.3

[drizzle]In the second article, “To Win with ‘Smart Beta’ Ask If the Price Is Right,” we show that valuations are predictive of future returns. We demonstrate that this result is robust across time, in international and emerging markets, and holds for various metrics used to measure valuations. We also point out that—for the moment, at least—many so-called smart beta strategies are trading in the top quartile, and even top decile, of historical valuations. We caution those who believe past is prologue and are tempted to extrapolate past “alpha” into expected future returns without regard to current valuation levels.

In this article we explore whether active timing of smart beta strategies and/or factor tilts can benefit investors. We find that performance can easily be improved by emphasizing the factors or strategies that are trading cheap relative to their historical norms and by deemphasizing the more expensive factors or strategies. We also observe that aggressive bets (favoring only the cheapest factor or smart beta strategy) can severely erode Sharpe ratios, so that gentle or moderate tilts toward that factor or strategy would seem to be a sensible compromise. Finally, we note that both factor and smart beta strategies have typically been identified and accepted as potentially alpha generating by the finance and investing communities after a period of impressive success—indeed, many of our own tests include a span that predates their discovery. We show that out-of-sample tests, after a strategy or factor has been discovered, are often far less impressive.

We Are All Market (and Factor) Timers!

How many times have we been drawn to a strategy, factor tilt, fund or ETF, asset class, or individual stock based on its past performance, goaded by a fear we’re missing out? How often are we repelled when a strategy, factor, fund, or manager has been persistently disappointing, driven by a concern that past is prologue? In seeking new sources of diversification, how often do we ask if the winners are newly expensive, poised to disappoint, or if the losing investments we may be ready to drop are newly cheap, poised to provide wonderful results? How often do we even consider selecting a poorly performing investment or strategy, thinking it may now be cheap? In each of these examples, we’re not only market timing, we’re performance chasing.

We’re all market timers, even in the halls of academe. Value investing goes back centuries, but the value factor, per se, wasn’t “discovered” in academic literature until 1977.4 In 1977, the Fama–French value portfolio (the 30% of the market with the highest book-to-price ratio) was priced more richly relative to the growth portfolio (the 30% with the lowest book-to-price ratio) than ever before or since, in data back to 1926. Similarly, the size effect was first published in the academic literature in 1981, near the end of its impressive 1975–mid-1983 run, and just ahead of a disastrous 15 years through 1999, during which the cumulative wealth of the Russell 2000 investor fell by more than half relative to the Russell 1000 investor.

Our experience from interacting with clients, investors, and market pundits suggests that many—including sophisticated large institutional investors—are already timing factors and smart beta strategies.5 Unfortunately, many are doing so in a self-destructive way by trimming reliance on newly cheap factors and strategies, while increasing allocations to newly expensive factors and strategies, activities detrimental to both Sharpe ratios and returns. Many investors have recently been scrambling to diversify their exposure to value. Is that not market timing and performance chasing? Of course it is!

When evaluating managers, mutual funds, and strategies, common practice is to look at both recent and long-term performance. Disappointing recent fund performance can be seen as a signal that the manager has “lost it,” perhaps by exhausting a source of alpha. Alternatively, it may signal that the manager did not have the skill to outperform in the first place. The possibility that the manager’s strategy is newly cheap (and therefore attractive) is rarely considered. A three- or five-year span, and often even a shorter spell, of underperformance—in extreme cases, just a few quarters—can suffice to get a manager fired; consequently, a subsequent reversal of shortfall would never be observed because the manager no longer manages the divested assets. To replace the underperforming managers, investors usually reallocate the divested funds to managers who have recently delivered wonderful performance.

Today in smart beta land we notice similar behavior. If a factor underperforms for multiple years (e.g., value’s recent nine-year span in the dog house!), investors question if the factor (or strategy) still works. Losing confidence in a particular strategy or factor, they may abandon it, trim it, or seek complementary strategies to diversify their risk. What strategies draw their attention? Generally only strategies or factors with superior recent performance.

Relative Valuation and Timing: How Well Does It Work?

Our first two articles explore the link between a strategy’s valuation and its performance. Predictably, many have been asking us if relative valuation can be used to tactically time alpha from smart beta strategies. The short answer is yes. The longer answer is it leads to a more concentrated risk profile. So, while it’s easy for the patient, long-term investor to earn higher returns from factor and smart

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