Here is the latest and most exhaustive in our ongoing attempt to ruin the fun for those who think contrarian factor timing is easy and for those who think current factor valuations are extreme, in spite of all of the evidence to the contrary for both.1
When you write a philippic on something, you generally hope you have put the matter to rest.2 But, my philippic was admittedly designed to be lighter on data (not bereft, just lighter) and heavier on argument. Our latest paper provides a lot of both. Still, much of the basic intuition remains the same.
I’d sum up the major points in the debate this way (admittedly much more bluntly than in the new, more academic paper, which covers a subset of the below):
• Initial results (over the last 1-2 years) using book-to-price as a valuation measure to calculate the “value spreads” of factors showed that some well-known factors were pretty expensive and some pretty cheap versus history (though none, despite the occasional rhetoric, even close to the extremes we saw in the Tech Bubble).3 When researchers (not just us at AQR) moved beyond just book-to-price, examining multiple factors on multiple measures of valuation, all the current readings got less extreme (closer to historical norms). It seems the initial book-to-price readings were an outlier.
• An appeal to time factors often includes an appeal to “common sense” and the idea that “price matters” as if anyone is disagreeing. Of course, price matters. Still, for instance, those truths don’t make timing the overall stock market based on historical CAPE an easy exercise. Similarly, it doesn’t make factor timing based on the value spreads we established in 1999 a walk in the park. Market timing (predicting and trading on these predictions for the overall stock market) is instructive for factor timing, a similar exercise. Adding value from market timing is very hard even though the aggregate market price (e.g., the CAPE) matters and varies a lot over time. 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!)4, and certainly not while they’re currently within historical bounds as they are today. In short, contrarian factor timing is likely harder than timing the stock market and is already being captured (in a more efficient manner) by those already allocating to the value factor, raising the hurdle for contrarian factor timing considerably.
• In multiple online white papers, Arnott and co-authors present evidence in support of contrarian factor timing based on a plethora of mostly inapplicable, exaggerated, and poorly designed tests that also flout research norms. For (non-exhaustive) example, they use long-horizon regressions for factors with too much turnover to make them applicable (among other things, please, please, please stop making 5-year forecasts for momentum!). They also have apples-to-oranges comparisons, with the most egregious being a comparison of contrarian factor timing based on a composite of valuation indicators, using up to date prices, to a simple book-to-price value factor using lagged prices (and declare the correlations lower than reality based on this poor comparison). They show a lot of graphs with end points excitedly marked (e.g., look where valuation got to before the deluge!) that are both too anecdotal and simply repeating that value is a good strategy (something still not in dispute) not that it should dominate the other factors (as it does if you add in too much contrarian timing). Mixing poorly designed research with ever increasing rhetoric, while living in your own universe and not explicitly referencing or dealing with relevant other work (that repeatedly points out much of the above and more), is just not how it’s supposed to be done. It’s ok to disagree and even to be wrong (e.g., looking back at our original paper using data in the Tech Bubble, I think we gave an overly optimistic impression of timing in general as the current conditions got us so worked up! Although, it certainly worked out in that scenario). It’s not ok to vary your techniques solely to achieve a certain outcome and repeatedly not address your critics.
• Yet, with all that said, there is still much to agree on and real value found in some of the messages in the papers by Arnott and co-authors. If you choose your factors based on only past performance, even long-term past performance, that can be a recipe for poor results in a world where data mining is a problem. If you choose your factors based on recent (say the last three to five years) good performance, that’s worse and a recipe for very poor results. These lessons are timeless, and anyone making these points is doing the lord’s investing work. I have always argued that chasing strong recent (again, say, the last five years – see peeve #3) performance is bad and would echo that for factors. Still, I don’t think the opposite, contrarian factor timing, is so good. This seeming contradiction is in fact reconciled by the power of diversification and the unnecessary pain induced by the lack of it. Remember, despite being the timing cynics, we have consistently found mild (again, mild!) positive power to contrarian factor selection. That is expected as, again, value is a good strategy, and this is just an attenuated (not the most efficient) form of value. Mild positive power doesn’t produce a great timing strategy, particularly when value is one of the factors being timed and presumably already present in the portfolio (again, you’re already getting contrarian factor timing from the regular old untimed value factor). But, at least such timing is in the right direction. One who does the opposite, perhaps by chasing five-year performance, however, gives up diversification (not to mention over-trading), while pursuing a mildly negative strategy instead of merely an insufficiently positive one. That’s now a real problem!
• Taking things further, it’s misguided to choose current factor exposures based solely, or even mostly, on price. Yes, price is very important. It’s why the value factor is so important. If that’s the only factor you like and believe in, then more power to you. Those who believe in other factors but only like them when they’re cheap are not really multi-factor investors. Instead, they are value investors who dabble. That’s fine if that’s truly all they believe in, but it is likely deeply suboptimal if they really believe in multiple