Market timing and smart beta
Rob Hayward
Introduction
Recall that Modern Portfolio Theory (MPT) says that investor should hold the market portfolio, weighted according to all the assets in the investment universe to achieve the maximum return per unit of risk. The level of risk can be determined by mixing the market portfolio with the risk-free asset.
However, the investment universe can be defined in different ways and there might be an argument to change the level of risk according to market conditions.
Market timing
Market timing is a style of investment that will seek to switch between the risk-free asset and the market portfolio depending on market conditions. Practically, this can mean switching between stocks and bonds.
Exercise 1.0
Download data from Yahoo finance for US stocks (S&P 500) and US bonds (US government)
Assess the relative performance of these two assets
Market timing can also relate to:
Equities: industry sectors. Investors may try to time the movement into cyclical stocks to coincide with an upturn in the economy.
Fixed income: duration and credit. Investors will take more duration and credit risk according to their assessment of economic and financial conditions.
Commodities: cyclical and structural. Investors may target cyclical commodities (steel, copper etc), structural changes that may affect supply and demand (i.e. climate change may reduce the demand for crude oil will raising the demand for trace metals that are used in batteries), or safety (gold)
Factor investment
Recall CAPM identifies the following equation:
\[ R_i = \alpha_i + \beta_i (MR -rf)\]
Where R is the return for security i, MR is the market return, rf is the risk-free rate, beta is the amount of market risk in the individual security and alpha is the excess return on top of the return for taking risk (beta). Market efficiency says that there is no alpha.
Beta is the market factor or equity risk premium. However, pretty soon market participants and academics found that beta was not very good at describing the returns for individual securities. Other factors have been identified. These include value and small capitalisation. Growth is a negative factor. A factor zoo has been added, including momentum, quality, defensive. Take a look at the FTW function on Bloomberg. Terman and risk factors have been identified for bonds.
Fama and French identified a three factor model. Eugene F. Fama and French (1993) and followed that up with a five factor model. Eugene F. Fama and French (2015). The factors that they identified.
Equity risk premium. This is the beta.
Size. Market capitalisation. Also called SMB as it may be created by buying small capitalisation stocks and selling large capitalisation stocks.
Value. Cheap relative to fundamentals. Also called HML as it may be created by buying companies with a high book-to-market valuation relative to those with low book-to-market valuation.
Quality. Robust earnings. Also called RMW as it may be created by buying companies with high or robust operating profitability and selling those with low or weak operating profitability.
Defensive. Cautious investment. Also called CMA as it may be created by buying companies with conservative investment activity relative to those with aggressive investment.
Factor models
There are three main ways to look at factor performance.
Build a portfolio of stocks with high factor values that is short low factor values and compare that to average stock returns.
Identify individual stocks that have high factor values.
Find exchange traded funds (ETF) that are based on factors.
Assessing the first of these is made easier by the database that has been created by economists Eugene Fama and Kenneth French at Dartmouth University. The second of these may be problematic if idiosyncratic risk is not diluted. For the third, it is possible to use the following list:
Exercise 2.0
Go to the Ken French factor library and download the current daily data for the standard Fama/French 5 Factors (2x3) (Daily) model. Read the Details to understand the data.
Import the data into R, ensure that the date is a date object.
Plot the 5 factors performance since July 1963. Which is the best performing?
Exercise 3.0
Write a one page report that covers the following questions:
What is the correlation between stocks and bonds?
How does this change over time?
What is the relationship between the correlation and the inflation rate?
What does this suggest for a 60:40 equity:bond portfolio?