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Timing Premiums: Why It Is Not A Good Idea

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Many investors have caught on to the idea of the different dimensions of expected return or “premiums” such as the market, size, relative price (value), profitability, and capital investment factors. We at IFA have long advocated for a passive investment strategy that targets these premiums through a globally diversified portfolio of index funds, which we believe is the best way to capture these premiums.

Some investment professionals have decided to take this a step further and suggest that investors can successfully time when they should be exposed to these types of premiums, or what the industry has decided to label “Smart Beta;” a nomenclature that we prefer not to use.

In a recent research article published by Research Affiliates entitled, “Timing ‘Smart Beta’ Strategies? Of Course! Buy Low, Sell High,” authors Rob Arnott, Noah Beck, and Vitali Kalesnik conclude that a contrarian approach where you emphasize factors that are trading “cheap” compared to historical norms and deemphasizing the more “expensive” factors can improve performance.

This is nothing particularly new. Robert Shiller is well known for his cyclically adjusted price-to-earnings (CAPE) ratio that compares the current versus historical valuation of the S&P 500 as a way of determining whether the stock market is currently trading “cheap” or “expensive.”

In a similar vein, Research Affiliates believes we can apply the same principles to factor or “Smart Beta” investing. Examining 8 different factors including value (blend), value (book-to-price), momentum, size, illiquidity, low beta, profitability, and investment, researches found that a contrarian approach, which emphasizes the 3 factors that have had the most recent relative underperformance (cheap) compared to the 3 factors who have had the most recent overperformance (expensive) has generated a relative outperformance of 7.2% per year which was statistically significant at the 99 % confidence level. This was based on the US stock market from January 1977 to August 2016. In the authors’ own words, “these timing strategies move into value when value is cheap and into growth-oriented factors, such as momentum and profitability, when they are cheap.”

But wait just a second….

While data can suggest a profitable strategy based on backtested data, it doesn’t necessarily mean that it can be profitably implemented in real life. In fact, researchers at Dimensional Fund Advisors have also looked into the validity of premium timing approaches to asset management.[i] Researcher Wei Dai, Ph.D examined 680 different trading strategies involving “trading back and forth between the long and the short sides of the premiums in an attempt to generate abnormal returns” focusing on both the magnitude and the reliability of the excess return compared to a long-only approach to a specific premium.

Based on her simulations, she found that 2.4% of the trading strategies generated a reliably positive excess return. The average excess return across all 680 different trading strategies was -0.10% per month with the highest being 0.10% per month and the lowest being -0.72% per month. In her own words, “there is fairly weak evidence supporting the predictive power of valuation spreads for future premiums at an annual horizon.” Further, she points out the more prevalent point that, “while good outcomes often attract the most attention, they can easily happen by chance, especially when there are a large number of simulations from which to cherry-pick.”

To give proper due, the authors of the Research Affiliates study acknowledged the inherent biases in their own research. They state, “if we had any way to eliminate the data mining and selection bias and to conduct a true out-of-sample test, results could only be worse for trend chasing [long only] (and admittedly, the benefits from contrarian trading strategies might also be less than the results we show here).”

A long term investment approach should be based on sound financial principles that have been proven empirically through rigorous research and statistical standards. You can easily torture the data until it tells you whatever you want it to tell you, but it won’t necessarily be in your best long term financial interest to do so. Beyond our disagreement with Research Affiliates that markets are not performing their most basic duty of setting fair prices (versus “cheap” or “expensive” prices), we also believe that it is highly unlikely that the Holy Grail of active management comes in the form of a simple market timing strategy of premiums. What is more likely is Lady Luck playing tricks on us once again.



[i] Dai, Wei, Ph.D. Premium Timing With Valuation Ratios. Dimensional Fund Advisors, LP. March 2016.