The findings from the two studies we examined are consistent with those of Cliff Asness, Swati Chandra, Antti Ilmanen and Ronen Israel, authors of the study “Contrarian Factor Timing Is Deceptively Difficult,” which appeared in the 2017 Special Issue of The Journal of Portfolio Management.
They found “lackluster results” when investigating the impact of value timing (in other words, whether dynamic allocations can improve the performance of a diversified, multi-style portfolio). They write: “Strategic diversification turns out to be a tough benchmark to beat.”
An obvious takeaway is that the research indicates you should not invest in funds that try to time factor premiums. Perhaps a less obvious—though equally important—takeaway is that, because different factors outperform at different stages, diversification across factors, rather than concentrating risk in a single factor, is the prudent strategy.
We can see the benefits of diversifying across factors in the following table, which shows the correlation of returns among factors across all four economic stages examined in the aforementioned study “Fama-French Factors and Business Cycles.” The table is from that paper.
Correlation Across Economic Stages
With the exception of the correlation between the value and investment factors, the correlations are all low to negative. However, correlations are not static. They change depending on the economic regime.
For example, during a recession, the correlation between HML and RMW switches from 0.1 to -0.3, indicating that value and proﬁtability have a small positive correlation, on average, but are negatively correlated in a recession. This demonstrates the benefits to value investors of adding exposure to the profitability factor. Similarly, the correlation between MOM and CMA switches from 0.0 to 0.4, indicating a fairly strong positive correlation between momentum and investment during a recession.
As tempting as the proposition might be, there doesn’t seem to be convincing evidence that a style-timing strategy can be expected to be profitable going forward. That said, if you are going to “sin” by trying to time factors based on either relative valuations (as Arnott suggests) or economic regime forecasts, I’d recommend following Asness’s advice to “sin a little.”
The bottom line is that the most prudent strategy for investors is to build portfolios strategically (as opposed to tactically) diversified across factors that show persistence in their premiums, have low correlation to other factors, are pervasive around the globe and across asset classes, have intuitive reasons to believe the premiums should persist (whether behavioral-based or risk-based) and are implementable (meaning they survive transaction costs).
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.