IQ INSIGHTS
Dynamic Timing of Advanced
Beta Strategies: Is it Possible?
of advanced beta portfolios as refined asset classes, it makes
sense to attempt to measure their valuation over time.
Realizing the usefulness of this information for investors, we
developed a simple method to track the valuation of advanced
beta factor portfolios. We also confirmed that historically
advanced beta premiums are positively related to these
valuations, meaning the method can help forecast strategy
performance. This analysis can, thus, help investors make a
more informed prediction of the long-term prospects for their
advanced beta portfolios and provide guidance for dynamic
rebalancing of portfolio weights.
by Ric Thomas, CFA and Rob Shapiro, CFA, CAIA
Investing in advanced beta strategies has evolved from a niche
concept into an established investment belief among many
institutional investors. The widespread acceptance of transparent,
rules-based strategies that seek to achieve active-like performance
by capturing specific risk premiums in the market is confirmed
by various studies and surveys, along with our own experience in
working with asset owners. We welcome this trend—it is a topic
we have long championed.
Initially, investors’ main consideration centered on which of the
advanced beta equity premiums—such as size (focused on the
added premium provided by small-cap stocks), value (provided
by stocks currently out of favor despite strong fundamentals),
quality, or low volatility—made the most strategic sense in a
diversified investment plan. But more recently, investors have
started to ask whether they can dynamically rotate the timing of
their exposure to these factors over the long term.
The timing question is an important one, because missing from
the advanced beta conversation so far has been a discussion of
the valuation of these factor portfolios. When investors seek to
alter a strategic allocation to equities, high yield bonds, or any
other asset class, they naturally look to valuation for guidance.
A sharply rising P/E ratio on equities, for example, is often
impetus for some investors to reduce their equity allocation
in favor of a cheaper growth asset class. Similarly, if we think
Precision and Timing: A Winning Combo for Implementing
Advanced Beta
The issue of timing has long been part of the discussion
surrounding advanced beta strategies. Investors often become
interested in advanced beta because of a view they have about
a particular risk premium in the market-for example gravitating
toward a low-volatility-tilted factor portfolio out of a concern
about the exposure of their existing holdings to tail-risk volatility.
The challenge with this approach is that a factor that may
be compelling during one market regime may be less so in
another. So some investors opt for a multi-factor portfolio, which
combines multiple factors in one portfolio to take advantage of
the potential diversification that a combination of risk premiums
provides over time. This method cuts down on the cyclicality of
choosing one factor and reduces turnover and transaction costs,
offering a kind of set-it-and-forget-it approach to implementing
advanced beta across a portfolio.
While the multi-factor approach offers much in the way of
convenience, it provides for a somewhat limited level of precision
and performance attribution. As such, many investors prefer a
third approach in which they separate advanced beta factors into
various distinct component portfolios, each organized around and
tilted toward a single attribute. That way, if investors become
more bullish on valuation and less so on low volatility, they can
dynamically re-weight the overall portfolio in the same way that
they might alter their equity-to-fixed income allocation.
The model we develop here for timing advanced beta factors can
be a particularly good complement to those investors who favor
segmenting their advanced beta allocations.
IQ INSIGHTS | THE TIME FACTOR
A Valuation Model for Advanced Beta Timing
This finding raises important questions for adherents of
Various studies show that a valuation-based approach provides
factor-based investing. Can valuation ratios also forecast
reasonably accurate long-term forecasts for asset prices. In
the returns on advanced beta portfolios? Are returns for low
particular, Campbell and Shiller (1998)1 showed that simple
volatility equity portfolios (or for quality, small-cap or value,
aggregate valuation ratios, such as price-to-earnings,
for that matter) poor when valuations for those kinds of stocks
dividend-to-price and book-value-to-price, could accurately
get expensive? Can we measure this valuation and is it possible
predict long-term equity market returns. They argued that
to create a rebalancing rule that favors attractively valued
P/E multiples are relatively constant in the long-run, always
advanced beta portfolios over time? The answer to all these
reverting back to a historical norm. Therefore, a high P/E ratio
questions, as we suggest above, is yes.
necessitates that either the numerator (P) must fall or the
denominator (E) must rise in order to bring the ratio back into
Analysis
equilibrium. In fact, they found it was price, not earnings that
Measuring the valuation of the various attributes themselves
adjusted to restore balance, dealing a blow to believers in market
we believe is straightforward. We simply divide the universe of
efficiency, who would have predicted that higher prices reflect a
stocks in the MSCI World into four different key attributes—
perfect sharing of information about the prospects for earnings
quality, low volatility, size and value. Within each attribute, we
growth (but, as we know, the efficient market hypothesis does
determine the top and bottom quintiles (i.e., the 20% highest
have its holes).
quality and lowest quality stocks, 20% least and most volatile,
etc.) and then calculate the median book-to-price ratios for each
Figure 1: Valuation Spreads of Advanced Beta Attributes
Value—Median B/P Spread
Size—Median B/P Spread
2.0
1.0
Attractive
1.6
0.8
1.2
0.6
0.8
0.4
0.4
0.0
0.2
Expensive
Jan
1987
— Spread
1993
— Average Spread
2000
2007
1 Std Dev Above
May
2014
1 Std Dev Below
Low Volatility—Median B/P Spread
0.4
Attractive
0.0
Expensive
Jan
1987
— Spread
1993
— Average Spread
2000
2007
1 Std Dev Above
May
2014
1 Std Dev Below
Quality—Median B/P Spread
Attractive
0.0
0.2
Attractive
-0.2
0.0
-0.4
-0.2
-0.6
-0.4
-0.6
-0.8
- 0.8
Expensive
Jan
1987
— Spread
1993
— Average Spread
2000
1 Std Dev Above
2007
May
2014
1 Std Dev Below
-1.0
Expensive
Jan
1987
— Spread
1993
— Average Spread
2000
1 Std Dev Above
2007
May
2014
1 Std Dev Below
Source: SSgA, MSCI
As of May 31, 2014.
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IQ INSIGHTS | THE TIME FACTOR
pair of quintiles. Finally, we take the difference between these
subsequent three-year excess return over the cap-weighted index
two ratios. A large spread between the ratios for the top and
of a long-only advanced beta portfolio organized around that
bottom quintiles implies that the attribute is attractively priced,
factor. The figure suggests that the return premiums to advanced
and a low number suggests that the attribute is expensive.
beta portfolios are time-varying but predictable.
Figure 1 plots these valuation ratios for the four distinct
While the plots confirm a positive relationship between valuation
advanced beta attributes over time.
spreads and subsequent returns, two challenges arise from
Consistent with Campbell and Shiller, the chart shows that
fully implementing a strategy based on this finding. First, the
the valuation ratios are relatively constant. An extreme level of
coefficient of determination, or “R-squared,” of these four
cheapness (such as found in size in 1999) tends to correct itself
relationships varies between 0.15 and 0.30. You can see this
and reverts back to a more normal ratio (such as found in size
intuitively by observing the relatively wide dispersion of the
in 2004). This observation leads to the question as to whether it
points around the lines in Figure 2. Hence, while the advanced
is prices, or book values, that adjust to restore this equilibrium.
beta portfolios may be predicable, there is certainly some
margin for error. Second, for each of the factors, the majority
A simple plot of the year-end valuation spreads relative to
of the data points lie above 0% on the Y-Axis. In other words,
forward subsequent returns indicates that, as with equities
for many investors, a simple buy and hold methodology with
as a whole, it is prices that adjust, and valuation spreads can
periodic static rebalancing may be enough, since in the long run
help forecast advanced beta returns. In Figure 2, each point
represents the book-to-price spread as of May 30, for each of the
various factors, between 1993 and 2010. The Y-axis shows the
many of these advanced beta portfolios tend to perform well,
even if the starting point of valuation isn’t optimal.
Figure 2: Valuation Spreads Versus Future Excess Returns
Size—Subsequent 3-Yr Excess Returns (Percent)
Value—Subsequent 3-Yr Excess Returns (Percent)
10
9
5
6
0
3
-5
0
-3
-10
0.0
0.5
1.0
1.5
-15
0
0.2
B/P Spreads
0.4
B/P Spreads
Low Volatility—Subsequent 3-Yr Excess Returns (Percent)
Quality—Subsequent 3-Yr Excess Returns (Percent)
20
6
0.6
0.8
4
10
2
0
0
-10
-20
-2
-0.6
-0.4
-0.2
B/P Spreads
0.0
0.2
-4
-0.8
-0.6
-0.4
B/P Spreads
-0.2
0.0
Source: SSgA, MSCI
As of May 31, 2014.
The calculation method for value added returns may show rounding differences.
Past Performance is not a guarantee of future results.
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IQ INSIGHTS | THE TIME FACTOR
The Results?
remaining three. Additionally, in order to mimic a “long-term
Let’s now test one simple rule that illustrates how an investor
mindset,” once a component portfolio is sold it cannot be
might apply this analysis to a dynamic rebalancing method.
repurchased for three years unless at some point the
Of course, armed with our analysis, there are many different
book-to-price ratio improves to a standard deviation of +1
approaches an investor can take, and the method shown
relative to the average spread (i.e., becoming cheap again).
here is but one of many possibilities.
Figure 3 shows the historical performance of this methodology.
The benchmark is a static equal-weighted portfolio of four
The chart shows that the timing method would have added
advanced beta component portfolios—size, valuation, quality
value over a purely equal-weighted method fairly consistently
and low volatility. For a possible implementation of a timing
over long periods of time. The example methodology we outline
strategy, an investor could simply divide a portfolio initially
here does not have overly high turnover and transaction costs,
into the same four equal weights. The investor would rebalance
and we believe that the added value should still be significant
the overall portfolio monthly, and continue to allocate to each
when such costs are accounted for. This finding provides
component equally, unless the book-to-price spread declines
some hope to investors wishing to maximize the return
by such an amount that it reaches a standard deviation of -1
premiums of their rules-based equity portfolios. It also
relative to the average spread (i.e. becoming too expensive).
highlights the importance, in general, of understanding the
In that case, the timing method completely sells out of the
valuation characteristics of factor portfolios before making a
expensive portfolio and reallocates the capital equally to the
long-term investment in them.
The Importance of Timing and Valuation
Figure 3: A Dynamic Advanced-Beta Methodology
It makes sense to have a good understanding of valuation
before making long-term allocations to any asset class, and
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valuation estimates can be applied to factor portfolios as well
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as they can to traditional asset classes. For those who because
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of turnover or other considerations do not wish to implement
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a dynamic re-balancing process, the valuation methodology
we present can be used to at least time their entry into the
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factor, or factors, of their choosing or help them decide which
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0
to access when. Given the long-term better risk-adjusted
Jan
1993
— MSCI World
1998
— Static Weights
2003
2008
Dec
2013
— Dynamic Weights
performance of advanced beta factors generally, we believe
the important thing may be merely to be invested in them.
Source: SSgA, MSCI
However, valuation does matter in the future performance of
As of May 31, 2014.
advanced beta portfolios over time, and implementing a simple
Past performance is not a guarantee of future results.
rules-based dynamic rebalancing method based on valuation
Index returns are unmanaged and do not reflect the deduction of any fees or expenses.
Index returns reflect all items of income, gain and loss and the reinvestment of dividends
and other income.
indeed offers the potential for enhanced returns.
1
Campbell, J. Y., and R. J. Shiller. “Valuation Ratios and the Long-Run Stock Market Outlook.”
Journal of Portfolio Management 24.2 (1998): 11-26.
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IQ INSIGHTS | THE TIME FACTOR
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