There’s been a wealth of evidence to suggest that, despite the promise that active managers have offered to investors, the vast majority of them are unable to outperform their respective benchmarks on a net-of-fee basis. And even when active mutual funds try to time the markets, research indicates that it doesn’t result in outperformance either.
But research into factor premiums has turned up evidence that they vary over time depending on the stage of a business cycle. Citing a December 2017 study titled Fama-French Factors and Business Cycles, Larry Swedroe recently noted that data covering the period from April 1953 to September 2015 show how six factors — market beta, size, value, momentum, investment, and profitability — yielded premiums that vary according to what stage in the business cycle the market is in.
“[F]actor premiums vary and are regime-dependent,” Swedroe wrote in a column for ETF.com. “That, of course, makes timing them tempting.”
Swedroe referred to an August 2018 study titled Risk Factor Exposure Variation and Mutual Fund Performance, which examined the success of active mutual funds at timing factor premiums (net of fees). The proponents of the study measured the volatility of funds’ factor exposures on market beta, size, value, and momentum. The overall level of factor timing was computed via an aggregated timing indicator that averaged and standardized the individual market, size, value and momentum timing measures.
The study, which looked at data from late 2000 through 2016, found a persistence in factor-timing activity, with 70% of all funds in the lowest timing decile remaining in the lowest three deciles after a year. Conversely, 70% of those in the highest timing decile stayed in the highest three after a year.
“High timing activity of an individual factor does not necessarily imply high timing activity to another factor,” Swedroe noted. And risk factor timing, he added, was associated with future fund underperformance: a portfolio consisting of the 20% of funds with the highest timing indicator underperformed a portfolio of the 20% with the lowest timing indicator by 134 basis points per year on a risk-adjusted basis. Even if fund were sorted on individual market beta, size, or momentum measures, the most actively timed funds still underperformed compared to the least actively timed funds.
“Risk factor timing is particularly prevalent among smaller mutual funds and those with long management tenure, high turnover, high total expense ratios and high past fund inflows,” Swedroe said. And funds with higher factor-timing activity were more likely to get ejected from the authors’ sample in succeeding years.
“Our results do not support the hypothesis that deviations in risk factor exposures are a signal of skill,” the researchers concluded. “[I]nvestors should resist the temptation to invest in funds that intentionally or coincidentally vary their exposure to risk factors over time.”
Swedroe also noted that because different factors outperform at different stages, a prudent strategy would be to diversify across factors rather than concentrating risk in a single factor.
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