Factor timing — dynamically adjusting factor exposures based on current valuations or other signals — is a contested topic. Two key papers offer contrasting perspectives.
Contrarian factor timing is deceptively difficult (Asness et al. 2017)
Asness, Chandra, Ilmanen, and Israel (AQR) examine whether value spreads (the cheapness of the long side vs. the short side of a factor portfolio) can be used to time factor allocations. Key findings:
- Factors as a group are not at extreme valuations (as of 2017); individual factors vary, but none are at bubble-like levels
- Tactical timing has lackluster results: dynamic allocations based on value spreads do not consistently beat strategic diversification across multiple factors
- Strategic diversification is a tough benchmark: the steady-state Sharpe ratio of a diversified multi-factor portfolio is hard to improve upon with timing
- Aggressive timing bets erode Sharpe ratios: concentrating in only the cheapest factor severely worsens risk-adjusted returns
- Gentle tilts are reasonable: modest contrarian tilts toward cheaper factors are defensible but add marginal value
The paper’s central message: the bar for factor timing is strategic diversification, not zero, and that bar is surprisingly high.
Timing smart beta — buy low, sell high (Arnott et al. 2016)
Arnott, Beck, Kalesnik, and West (Research Affiliates) take a more optimistic view of factor timing:
- Valuations predict factor returns: value spreads have significant out-of-sample predictive power for subsequent factor returns, across time and international markets
- Structural vs. revaluation alpha: past factor returns should be decomposed into structural alpha (net of valuation changes) and revaluation alpha (from rising valuations, which is non-recurring and may reverse)
- Many factors are expensive when discovered: academic publication and subsequent inflows tend to coincide with rich valuations, making out-of-sample performance worse than in-sample
- Performance chasing destroys value: investors who chase recently hot factors and drop cold ones are implicitly timing factors in a self-destructive way
- Moderate contrarian tilts help: emphasizing cheap factors and de-emphasizing expensive ones improves performance, but aggressive bets are dangerous
Synthesis
Both papers agree that (1) value spreads contain information about future factor returns, (2) aggressive timing is dangerous, and (3) strategic diversification should be the baseline. They disagree on whether the signal is strong enough to act on: Asness et al. emphasize that timing barely beats static allocation, while Arnott et al. emphasize that ignoring valuations is itself a form of implicit (and bad) timing.