In 2015, Cliff Asness made the case that to earn attractive returns with proper risk-based diversification and low correlation to traditional markets, investors need to embrace ‘the three dirty words in finance,’ which he defined as leverage, short-selling, and derivatives. (Asness, 2015)
In deference to George Carlin’s seven dirty words, I believe that we should expand Cliff’s list to include the dirtiest word of all: market timing. To be sure, there are other dirty words in finance, like concentration, illiquidity and high cost, but I think that market timing may be the dirtiest of them all.
Cliff used his list of dirty words to promote AQR’s Style Premia products (and some other funds, albeit less directly) and I believe that market timing is the key driver behinds AQR’s largest suite of mutual fund offerings: managed futures funds.
Managed futures, or trend following, involves buying securities whose prices are generally rising and selling assets whose prices are generally falling. I believe that managed futures managers time the market (or markets: stocks, bonds, commodities, and currencies) using price trend as their timing signal (an example of this research is here).
Nearly everyone in the investment community, from academics to practitioners believe that successful market timing is impossible. If managed futures strategies are essentially market timing, however, then successful market timing is not only possible but a potentially attractive addition to a well-diversified portfolio.
What is Market Timing?
While everyone may have an intuitive understanding of market timing, a clear cut definition is hard to find. The landmark paper by Brinson et al. that turned market timing into a dirty word says that it is “the strategic under or overweighting of an asset class relative to its normal weight, for the purpose of return enhancement and/or risk reduction.” (Brinson, 1995)
Other definitions include the idea that market timing must include a forecast derived from factors like economic fundamentals, valuation, etc. These definitions exclude managed futures as a type of market timing because trend following doesn’t require any forecasts or predictions since the strategy is backward-looking and reactive.
In my view, the definitions that include forecasts are too restrictive because the key factor in market timing isn’t the rationale, but the simple act of intentionally shifting a portfolio’s beta. Some investors may use forecasts to add or subtract beta, but the forecasts aren’t a necessary condition. Managed futures managers add and subtract beta based on price trends.
The following chart plots how trend followers may add and subtract beta based on market trends. The left axis shows the rolling beta of a trend-following factor to the MSCI World Index. For this chart, I used the equity component of a time-series momentum factor (TSMOM) created by academics (also affiliated with AQR) Moskowitz, Ooi and Pedersen related to their 2012 paper, Time Series Momentum. (data are available here). The right axis depicts the corresponding MSCI World index return.
Although the relationship isn’t perfect, it does appear that there is a relationship between the beta of a basic equity trend-following strategy and market returns. Based on the TSMOM factor rules, a trend-follower would have added to the beta as markets as the MSCI World was rising and when the index was falling. This relationship is, in effect, timing the market based on market returns.
Timing the Market, Poorly
Market timing gets a bad rap for good reason: it’s usually unsuccessful.
In 1966, Jack Treynor and Kay Mazuy were among the first academics to formally address whether mutual funds were successful at their market timing efforts. They analyzed 57 open-ended mutual funds between 1953 and 1962, and only one fund successfully timed the market. The researchers concluded that mutual fund managers could not anticipate major market movements and profit from them accordingly. (Treynor, 1966)
Since then, variations of this study have been conducted many times that include investment clubs, pensions, newsletters, professional market timers and asset allocation funds. The results vary some by study, but the basic conclusion is always the same: on average, market timing underperformed buy-and-hold investing.
For several years, Morningstar has researched investor performance in a study called “Mind the Gap.” They compare the time weighted returns of mutual funds to the dollar-weighted returns achieved by the fund’s investors. Morningstar concludes that, “Investor returns fall short of a fund’s stated time-weighted returns because, in aggregate, people tend to buy after a fund has gained value and sell after it has lost value.”(Morningstar, 2016)
Maybe performance chasing by retail investors isn’t the same as market timing by professional investors, but a recent paper by AQR suggests that ‘Superstar Investors’ don’t get much out of market timing either. The AQR researchers found that the returns for Warren Buffet, Bill Gross, and Peter Lynch are mostly explained by exposure to classic factors (market, value, credit, etc.). Only George Soros realized some true alpha through successful market timing. (Morn
It’s easy to see why market timing is a dirty word given the piles of academic studies, the poor investor returns and that even the superstars aren’t benefitting from it.
Timing the Market with Managed Futures
While the evidence was piling up against market timing as a whole, one group of investors was timing the market by following price trends: Commodity Trading Advisors (CTAs) and other trend followers in the managed futures industry.
The industry is relatively new dating back to the 1970s, and high-quality performance data is difficult to find. BarclayHedge tracks the performance of CTAs in an index that started with 15 constituents in 1980, versus 532 today. According to their website, the Barclay CTA Index gained 9.6 percent since inception, compared to 11.5 percent for the S&P 500.
Another well-known CTA performance tracker is the HFR Macro: Systematic Diversified Index that tracks trend follower’s dates back to 1990. The HFRI index shows that since inception, systematic trend followers have earned 9.4 percent annually, an even match with the S&P 500.
This data likely has some backward looking biases, which we can evaluate by comparing the two data sets. Since 1990, for example, the BarclayHedge returns only have a 0.4 correlation with the HFRI index. If the data were solid, we would expect a much higher correlation between them, like over the past five years, when the indexes have converged. Now the correlation is nearly perfect, but it was low and even negative in previous years.
Given the data problems and relatively short period, academic and commercial researchers have built factors and back-tests to try and understand whether the strategy is persistent and pervasive. The Time Series Momentum paper referenced above by the chart found that 58 liquid futures contracts across four asset classes using a relatively simple strategy from 1985 through 2009 earned 16.1 percent, compared to 8.2 percent for the S&P 500 over the same period. (Moskowitz, Ooi and Pedersen, 2012)
Two years later, the same academics conducted a 135-year survey and found similar results. Over the entire study period, the strategy earned 14.9 percent gross of fees and 11.2