FACTOR TIMING: Going contrarian

FishBuying underperforming investment factors could add additional returns in the longer run, but as with all contrarian investing, it’s difficult to pull off. By Lynn Strongin Dodds.

Contrarian investing is not a new theme but some participants are questioning whether the investment approach, based on betting against the market, can be used in the smart beta sphere, which itself goes against the traditional practice of referencing market-cap benchmarks.

While some believe buying underperforming investment factors could add additional returns, others argue that timing, whether in active or hybrid strategies, is always tricky to pull off. In fact, a debate is raging between two smart beta or factor-based veterans: Cliff Asness, founder of AQR Capital Management, and Research Affiliates chief executive officer Rob Arnott. 

Ari Polychronopoulos, senior vice president, product management at Research Affiliates, says: “Factors are not unlike stocks, bonds or other asset classes in that performance varies over time and depends on valuations.

“However, before you jump in, there are the questions of how practical is it and can investors effectively time factors. It is also important to note that certain smart beta strategies such as value have a stronger contrarian element than others.” 

His colleague, Vitali Kalesnik, head of equity research (and with Arnott and Noah Beck, author of a report, ‘Timing “Smart Beta” Strategies? Of Course! Buy Low’) also stressed the importance of valuations. Their research showed that taking a contrarian view can improve performance by emphasising factors or strategies that are cheap relative to their own historical norms and de-emphasising the more expensive ones.

While this is a form of value investing, the paper is careful to point out that it is not the same thing as doubling down on value risk. Instead it is focusing on relative valuation which can support investing in the factor when value is cheaply priced and, conversely, can indicate avoiding it when valuations become too frothy.

“The most important thing, although many investors do it, is to avoid trend chasing because it can hurt performance,” Kalesnik says. “We think they should commit to the process, identify and allocate to factors that they are comfortable with and then create a rebalancing schedule to readjust to a pre-determined weight.”

Entry point
Julien Turc, head of cross-asset quantitative strategy at Societe Generale, also believes there is too much trend following in smart beta as the concept has grown in popularity. The latest figures show that the products garnered a net $24 billion (€21.3 billion) in the first three months of the year, up from $1 billion during the same period in 2016, according to data provider ETFGI. 

“Finding the right entry point can be difficult because it pays you to chase the herd,” he says. “However, if the trend is too strong, performance suffers, correlations narrow and investors can be too exposed. The objective is to capture that breaking point before it happens.” He advocates a systematic approach that adopts a cross-sectional relative value view – identifying factors based on whether they look cheap or expensive to other factors, as well as measuring the returns of individual factors.

Although these strategies can be employed for equities and fixed income, finding the right opening in foreign exchange may be less challenging than most, given that inherently it’s a value trade. “I think the question can be applied conceptually to other asset classes,” says James Wood-Collins, CEO of Record Currency Management. “It is easier in FX because there are so many currency pairs for diversification, but if you are looking to time the reversal of a trend, the question will always be, is this the turning point or am I too late? Overall, the investor has to accept that you cannot time every move perfectly. There are a lot of entry points in an upward trajectory and they can all be profitable trades. The same is true on the downside, but the cost of timing has to be managed more carefully.”

Others like Asness contend that diversification is the best way forward and that timing smart beta strategies by buying when cheap and selling as valuations rise is ultimately dangerous. As Asness notes: “Smart beta managers have an incentive to claim they can do this as they seek to defend higher fees, but it’s unlikely that they can. It’s better to have a diversified exposure to a mix of factors that work over the long term. If investors do decide to time factors, they should only do so a little.” 

Together with three AQR co-authors - Swati Chandra, Antti Ilmanen, and Ronen Israel - Asness puts Research Affiliates’ conclusions through their paces by first evaluating whether any factors are overvalued and then by applying a value-based timing strategy to a multi-factor portfolio.

They noted that “while, not surprisingly, some of these factors are cheaper and some are richer compared to historical norms, none are near bubble-level extremes and collectively they do not paint a picture of very stretched valuations in either direction”.

Moreover, they measured the performance of single and multi-factor strategies when each of the factors was and was not timed. While value timing did improve returns and Sharpe ratios for a momentum portfolio, they stated that this diversification benefit could be more efficiently achieved by simply adding a strategic allocation to value.

The authors also found that as the baseline portfolio became more varied with a multitude of factors, it became “progressively harder for value timing to improve its performance” - even before considering the added turnover and transaction costs resulting from factor timing. As a result, they supported sticking to a “diversified portfolio of uncorrelated factors that you believe in for the long term, instead of seeking to tactically time them”.

Asness is not alone in his views. A new research paper from S&P Dow Jones Indices, ‘The Merits and Methodology of Multi-Factor Investing’, supports AQR’s view that factor diversification is the best way forward for those looking to avoid the risk of choosing between single factor strategies. Although they noted that as with any investment proposition, there were bumps along the way, it revealed that the classic strategies such as value, momentum, low volatility and quality based on the S&P 500 often outperformed the underlying index during most time horizons during the 1986 to 2017 period it tracked.

An equally weighted portfolio of factors, though, performed as well or better than the best-performing single factors over all time horizons. Overall, it found that the diversification benefit of holding equal exposure between the four single factor indices contributed to outperformance of the portfolio 80% of the time compared to the S&P 500 over a one-year period and 97% of the time over a three-year period.

Adam Laird, head of ETF strategy for Northern Europe at Lxyor, also sees the benefit of equal weighting. He believes that “contrarian investing is essentially a question of market timing – can you catch the next wave by buying underperforming factors? There are some who can, but it’s very difficult. For most, I’d say it’s not worth it.  Take value stocks. In the long run, value’s been shown to outperform, but for much of the last few years, it has been underperforming growth stocks.”

He adds: “Throughout, investors have highlighted that the growing differential in valuations could be a positive indicator – and for years it disappointed. Value has started to pick up in the last few months, but investors who bought in too early may still be disappointed – if they have even held on this long.”

He also notes that it can be dangerous to view smart beta in terms of market timing. “We believe a better approach is to think in terms of long-term objectives and to ask what are your aims: protecting yourself from risk, targeting income, enhancing returns? Smart beta comes into its own when it can join up a portfolio with investors’ needs.”

According to Laird, Lxyor conducted its own research into factor weighting a few years ago while preparing for the launch of its two multi-factor index ETFs: Lyxor JP Morgan Multi-Factor Europe Index Ucits ETF and Lyxor JP Morgan Multi-Factor World Index Ucits ETF. “We asked the question, ‘What strategy for choosing factors gives the best returns?’

“In the end, we chose to equally weight five factors – value, size, momentum, quality and low beta. The marginal benefits from using a more complex construction weren’t large enough or consistent enough to justify the additional stages.”

“The most important thing to remember is that although timing is difficult, funds should not be static and allocations should be rebalanced,” says James Price, senior investment consultant at Willis Tower Watson. “The underlying stocks that are in these strategies, whether it be value, momentum, quality or low-vol, are going to change due to market conditions and behavioural biases. Investors have to recognise that there is no free lunch and they come with a risk of underperformance.”

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