On the Expected Performance of Market
Timing Strategies

Abstract

The author derives expressions for the information ratio (IR) that can be expected from directional market-timing strategies. The results hold as accurate approximations and lift the Fundamental Law of Active Management proposed by Richard Grinold in 1989 to an operational level. In addition, the author separates time series-breadth (the timing frequency per strategy) from cross-section breadth (the number of separate markets), because they contribute differently to performance. The author shows that implementing volatility-weighted bet sizes, both in the time series context of a single underlying market and in the cross-section context of multiple markets, increases the expected timing IR. His theoretical results can be used as a benchmark for and reality check on the back-tested performance of timing strategies. He confirms the accuracy of his results by simulating timing strategies for equities and fixed income.

TOPICS: Exchanges/markets/clearinghouses, volatility measures, statistical methods