Contrarian Factor Timing is Deceptively Difficult

Abstract

The increasing popularity of factor investing has led to valuation concerns among some contrarian-minded investors, and fears of imminent mean-reversion and underperformance. The authors find that despite their recent popularity, the most common factors or styles are not, in general, markedly overvalued as measured by their value spreads. More broadly, tactical timing, whether of markets or factors, always seems to hold appeal for many. The authors look at the general efficacy of value spreads in predicting future returns to styles. At first glance, valuation-based timing of styles appears promising, which is not surprising because it is a simple consequence of the efficacy of the value strategy itself. Yet when the authors implement value timing in a multi-style framework that already includes the value style, they find somewhat disappointing results. Because value timing of factors is correlated to the standard value factor, it adds further value exposure—but does so intermittently and suboptimally compared to an explicit risk-targeted strategic allocation to value. Thus, tactical value timing can reduce diversification and detract from the performance of a multi-style strategy that already includes value. Finally, the authors explore whether value timing works better at longer holding periods or at extremes, still finding fairly weak results. They find that contrarian value timing of factors is, generally, a weak addition for long-term investors holding well-diversified factors including value, and specifically, it does not send a strong signal on stretched valuations today.