A risk-reducing factor
Many factor investors use timing as a way to reduce risks, writes David Turner
At a glance
• Most factor-based investors say they do not time investing to increase short-term returns.
• However, many time their investments to reduce risk.
• High concentrations in particular factors increase risk.
• Any higher gross returns through factor timing largely disappear after trading costs.
Opponents of factor timing liken it to the fable of the geese that laid the golden eggs.
The unusual waterfowl produced one golden egg each day, enough to produce an excellent living for the humble peasant who owned it. However, he became greedy and supposed that the hen must contain a great lump of gold inside. To extract this gold, he killed the goose, only to find no gold. He could not even fall back on the daily egg, since the goose was dead. The moral of the story: do not ruin a profitable enterprise by trying to squeeze out even more profit.
However, advocates of factor timing – adjusting investments in different factors based on a sense of whether the time is right to be in or out of them – say that, if done well, it produces extra return. In many cases they argue that this extra return is achieved through reducing risk, and thus minimising the ill effect of overvaluations and excessive risk concentration.
The debate has become fiercer recently because of a very public battle between two high-profile investors – Cliff Asness, co-founder of AQR Capital Management, whose $175bn (€164bn) in asset under management (AUM) is almost entirely based on factor investing, and Rob Arnott, co-founder of Research Affiliates and a Pioneer of the factor-timing discipline.
Arnott warned back in February 2016 that a bubble was forming in factor-based funds, which have grown rapidly; the value of investments based on MSCI’s factor indices, for example, has quadrupled from $44bn in 2012 to $180bn in the third quarter of 2016. He has argued that investors should be on the lookout for overvaluations, although he does not advocate the converse – piling into strategies that appear undervalued.
Greenwich, Connecticut-based Asness tells IPE, on the other hand: “Despite the rhetoric that calls 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 certainly not while they’re currently within historical bounds as they are today.”
Even so, Asness is far from doctrinaire in his approach. “Here’s one aspect that is indeed common sense in my view – and a topic on which I’d guess there is broad agreement,” he says. “If we see valuations (such as factor-value spreads) that are epically different than the past, then it’s time to have a new conversation.” He points to the example of 1999-2000, when “the value factor and the low-beta factor were super-cheap”.
He emphasises, however, that “this is not where we are today”; relative valuations are not dramatically different from what they were in the past.
Professor Peter Meier, head of the Centre for Asset Management at the ZHAW Zurich University of Applied Sciences in Winterthur, is also wary of dabbling in factor timing. “There is some premium if this is done correctly,” he says. “But because of the transaction costs, the premium is not too high.” This largely chimes with the thinking of Joop Huij, head of factor investing for equities and head of factor index research at Robeco in Rotterdam. He says: “We do find some predictive power through our testing, but the moment that one starts to incorporate trading costs because of the increased turnover, this takes away most of the potential value-added.”
Moreover, the consequences of timing factors incorrectly are dire. “This would have to be done systematically, in a very professional way,” says Meier. “People who are just speculators – buying when values are going up, without shorting to counterbalance this – can lose a lot of money.” The speculators fall prey, he says, to “behavioural bias” – trading based on their own imperfect perceptions, rather than relying on a system based on momentum investing.
Meier concludes that, for investors who want to invest using a momentum strategy – in other words, a systematic form of timing markets – a commodity trading adviser (CTA) trend-following style offers a better chance of a higher return.
However, the question of whether individual smart beta managers are timing factors is often far from straightforward.
Amundi, for example, engages not in timing but in risk control, according to Bruno Taillardat, the firm’s global head of smart beta in Paris. “I don’t think timing is the best way to deliver long-term performance,” he says. However, he notes that Amundi, which has a smart beta AUM of €12bn, does trim its allocation to individual factors “if they exhibit very high multiples compared to their own historical multiples”. His justification is not that Amundi is trying to time the market; it is, rather, that remaining invested at very high valuations “will create additional volatility and risk”. Its changing of allocations to different factors is, in other words, designed as risk management, rather than speculation.
So far, Taillardat does not sound that different from Asness of AQR, or even Arnott of Research Affiliates – the views of the two Americans have more in common with Amundi than each may admit. Where Taillardat does differ from Asness, however, is in the everyday actualities of risk management. Far from seeing the need to trim overvalued assets as a mere theoretical possibility, he says that Amundi engages in it regularly. In 2014, for example, the firm dispensed with some securities in its low-volatility strategy that paid good and predictable dividends, since too many investors, tired of low bond rates, had piled into them because of their status as bond-like stocks. Amundi, in fact, makes changes on a quarterly basis, or more immediately if necessary.
La Française Investment Solutions says that it is engaging in risk management rather than factor timing in its €1.5bn factor-investing strategy. When the correlation between two factors increases, La Française decreases the weights of both factors in the portfolio. In so doing, it shores up the diversification within the portfolio and, therefore, its Sharpe ratio. This paid off last year, when it reduced its weightings in both momentum and quality equity factors for this reason, while making up the difference by increasing the value weighting.
Luc Dumontier, the firm’s head of factor investing in Paris, notes: “The rebound in value stocks and simultaneous plunge in low-risk, quality stocks starting in April 2016 allowed our portfolio of equity factors significantly to outperform other funds that maintained an equal allocation to these three theoretically uncorrelated factors.” He adds, however: “We did not overweight the value factor because we thought it would outperform the others – the generally understood definition of factor timing. We overweighted it to conserve a balanced risk allocation between the different factors, the approach which we think has the best chance to deliver stable returns over the long term.”
The Railways Pension Scheme, which puts about three quarters of its equities allocation, or about £9bn (€10.5bn), in five factor strategies, goes for the more simple approach of always trying to have one fifth in each. Its prime justification for equal weighting is that it reduces risk by diversifying the portfolio. However, Steve Artingstall, investment manager in London, argues that even the process of maintaining an equal weighting “is a form of timing: we are buying into weakness and selling into strength”.
In conclusion, the question of whether investment managers are timing factors is a complex one. Judging by their comments, most engage in factor timing of some sort, even if most do it to reduce risk rather than to predict a particular turn in the markets at a particular time.