To Time or Not to Time? (Part 2)

If factor-timing has any place at all in a portfolio, it will be important to keep factor tilts modest to maintain diversification.

Alex Bryan 15 November, 2018 | 8:00
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It is well-established that valuations can predict long-term asset returns (lower valuations are associ­ated with higher future returns). This is true of asset classes, individual securities, and portfolios of securities. But that does not necessarily mean that valuations are an effective timing signal. For example, the U.S. stock market has been trading well above its historical average cyclically adjusted price/earnings ratio, or CAPE (based on data from 1880), since 2010. However, anyone who acted on that information—trimming or liquidating their U.S. stock allocation—probably regretted it, as the market delivered strong performance from January 2010 through August 2018 despite its seemingly high valuation. 

If using valuations to time the market is hard, using them to time factors might be even harder, as Cliff Asness and his colleagues at AQR argue in their paper, “Contrarian Factor Timing is Deceptively Difficult.”3 That’s because turnover in these portfolios reduces the predictive power of their valuations, as many of the current holdings may not stay in the portfolio long. Portfolio-level valuations are particularly unreli­able for high-turnover strategies like momentum.

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About Author

Alex Bryan

Alex Bryan  is the Director of Passive Fund Research with Morningstar.

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