The Temptation to Time

My colleague Josh Brown pointed out a surprising fact on fund flow data last week. It turns out the most heavily purchased ETF in 2016 is the iShares MSCI USA Minimum Volatility ETF (USMV). This relatively unknown fund has taken in $4.5 billion this year alone, an increase of 50% in assets from the end of 2015.

Low volatility stocks have been performing well in a market that hasn’t really gone anywhere for the past 18 months, so the inflows have followed. As factor investing — or smart beta, enhanced indexing, strategic beta, quantitative investing, etc. — continues to gain in popularity you can expect more of this performance chasing to occur. The ease of access to buy and sell these types of strategies and the fact that investors are impatient almost guarantees it. Investors have a hard time watching others make money when they aren’t.

Nothing works all the time so there will always be relative winners and losers among the different factors such as value, momentum, quality, yield, low vol, etc. Seeing these performance differences can cause investors to try to time these factors by side-stepping the laggards and over-weighting the winners. Sounds great in theory, but it’s not so easy in practice.

AQR’s Cliff Asness covered the problem with factor timing in a research paper published last month. I picked out a few of my favorite selections from the paper. It’s funny to me that investors are now thinking about factors like they used to think about individual stocks and asking for outlooks on their potential performance:

Everyone seems to want to time factors. Often the first question after an initial discussion of factors is “ok, what’s the current outlook?” And the common answer, “the same as usual,” is often unsatisfying.

Even though these factors will certainly see crashes in the future, that doesn’t invalidate a solid long-term thesis:

I make the analogy to knowing that the stock market will one day suffer a short painful “crash” does not mean one doesn’t invest in stocks for the long run.

These factors, like the stock market itself, are now well-known and will indeed possibly “crash” at some point in the future. I think that comes with the territory when investing in the known (and investing in the known can still be a wonderful long-term decision). Invest in these factors if you believe in them for the long-term and be prepared to survive, not miraculously time, turning points. Stick with your long term plan.

One of easiest ways to stay out of the factor timing game is by utilizing multiple strategies in a portfolio. Diversification among risk factors is fairly under-rated in my view:

Focus most on what factors you believe in over the very long haul based on both evidence (particularly out-of-sample evidence including that in other asset classes) and economic theory. Diversify across these factors and harvest/access them cost-effectively.

Good factors and diversification easily, in my view, trump the potential of factor timing.

Asness offers very sound, reasonable advice here. Unfortunately, sound and reasonable advice is very easy to understand, but very difficult to put into practice, especially under pressure situations. In his book, Rational Expectations: Asset Allocation for Investing AdultsBill Bernstein covers why these pressure situations are the where investors will earn their premiums on these factors:

Some worry that since large institutional funds — particularly hedge funds and ETFs — are now chasing these factors, these premiums will erode or disappear. This may be true in normal times, but in bad states of the world, to paraphrase Billy Ray Valentine in Trading Places, the suckers will get cleared out — not just naive small investors, but also hedge funds, which will be forced to unload their positions as their clients pull out and their liquidity — that is, their sources of leverage — dries up faster than a rain gully in the desert. This will likely produce, as happened in 2008-2009, a sharp contraction in prices that will remind investors of the risk of the value and small premiums, and so set the stage for subsequent higher returns.

I get questions from investors on a regular basis about my thoughts on various factor investing strategies. Will they stop working? What are the best factors? Is now the right time to over/under-weight certain factors? Will ETF flows cause these strategies to crash?

The temptation to time long-term strategies in the short-term is always strong because it’s not easy to follow a plan during the tough times.

Diversification, a long-term mindset and the discipline to stick with evidence-based investment strategies is the type of boring advice that people don’t really want to hear. But boring advice is often the best type of financial advice because successful investing is usually quite boring.

Sources:
The Siren Song of Factor Timing (AQR)
Rational Expectations: Asset Allocation for Investing Adults

Further Reading:
Smart Beta Crash Coming?

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