Timing Stock Factor/Smart Beta Strategies

Is stock factor timing attractive? In their September 2016 paper entitled “Timing ‘Smart Beta’ Strategies? Of Course! Buy Low, Sell High!”, Robert Arnott, Noah Beck and Vitali Kalesnik investigate whether timing of stock factor (long-short) and smart beta (long-only) strategies is attractive. They consider eight widely used factors and eight smart beta strategies. Each factor portfolio is long (short) the 30% of large-capitalization stocks with the highest (lowest) expected returns for that factor. They test both past returns and relative valuation (average valuation of factor long side divided by average valuation of factor short side) as timing signals. Their stock valuation metric is an aggregate of price-to-five-year-earnings, price-to-five-year-sales, price-to-five-year-dividends and price-to-book ratio, each measured relative to that of the capitalization-weighted universe of stocks. They standardize relative valuations across factors by dividing the difference between a current relative valuation and its past average relative valuation by the standard deviation of its past relative valuations. For factor timing portfolios, their benchmark is the equally weighted average of factor portfolio returns. For smart beta strategies, their benchmark is the capitalization weighted stock universe. They ignore frictions and shorting costs involved in portfolio maintenance. Using inputs as specified in factor and smart beta definitions during January 1977 through August 2016, they find that: (more…)