The Dirtiest Word In Finance: Market Timing

In 2015, Cliff Asness made the case that to earn attractive returns with proper risk-based diversification and low correlation to traditional markets, investors need to embrace ‘the three dirty words in finance,’ which he defined as leverage, short-selling, and derivatives. (Asness, 2015)

In deference to George Carlin’s seven dirty words, I believe that we should expand Cliff’s list to include the dirtiest word of all: market timing. To be sure, there are other dirty words in finance, like concentration, illiquidity and high cost, but I think that market timing may be the dirtiest of them all.

Cliff used his list of dirty words to promote AQR’s Style Premia products (and some other funds, albeit less directly) and I believe that market timing is the key driver behinds AQR’s largest suite of mutual fund offerings: managed futures funds.

Managed futures, or trend following, involves buying securities whose prices are generally rising and selling assets whose prices are generally falling. I believe that managed futures managers time the market (or markets: stocks, bonds, commodities, and currencies) using price trend as their timing signal (an example of this research is here).

Nearly everyone in the investment community, from academics to practitioners believe that successful market timing is impossible. If managed futures strategies are essentially market timing, however, then successful market timing is not only possible but a potentially attractive addition to a well-diversified portfolio.

What is Market Timing?

While everyone may have an intuitive understanding of market timing, a clear cut definition is hard to find. The landmark paper by Brinson et al. that turned market timing into a dirty word says that it is “the strategic under or overweighting of an asset class relative to its normal weight, for the purpose of return enhancement and/or risk reduction.” (Brinson, 1995)

Other definitions include the idea that market timing must include a forecast derived from factors like economic fundamentals, valuation, etc. These definitions exclude managed futures as a type of market timing because trend following doesn’t require any forecasts or predictions since the strategy is backward-looking and reactive.

In my view, the definitions that include forecasts are too restrictive because the key factor in market timing isn’t the rationale, but the simple act of intentionally shifting a portfolio’s beta. Some investors may use forecasts to add or subtract beta, but the forecasts aren’t a necessary condition. Managed futures managers add and subtract beta based on price trends.

The following chart plots how trend followers may add and subtract beta based on market trends. The left axis shows the rolling beta of a trend-following factor to the MSCI World Index. For this chart, I used the equity component of a time-series momentum factor (TSMOM) created by academics (also affiliated with AQR) Moskowitz, Ooi and Pedersen related to their 2012 paper, Time Series Momentum. (data are available here). The right axis depicts the corresponding MSCI World index return.

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