Is Factor Timing a Legitimate Source of Alpha?
Personally, I think it can be. I feel like there can be skill in deciding whether growth will outperform value, whether large cap will outperform small cap, or whether the market as a whole will produce attractive returns. I'm curious to hear the different sides to this debate and the implications for how active managers should be compensated.
I was gonna ask about people's thoughts on factor timing on WSO back then funnily enough, but decided fuck it.
I think the reams of evidence is pretty conclusive that no one can ever do factor timing (consistently). Market timing in general (like just 'buying the dip' etc) is hard enough (and the evidence also already shows no one can do that consistently), let alone factor timing.
Going on a tangent, I think this mindset shift by Morgan Housel crystallizes it best - risk is the PRICE of your return. There's no cheating around it. Think about risk as the ADMISSIONS TICKET to a Disneyland - you have to pay for it to watch the show, so most people do so willingly. Problem is, most people think of risk as a speeding ticket/ fine, not an admissions ticket, and they try to avoid it. They think risk is a punishment that could've been avoided (speeding ticket), instead of a price that has to be paid (Disneyland ticket).
If you look at historical returns in hindsight and just take out the couple biggest crashes, you'd have a monster return, but who on earth can time that ex ante? People who try to cheat their away around it will be punished.
Theoretically, if a PM could hypothetically factor time tho, that'd be positive alpha in the model, since by definition alpha is returns (presumably driven by skill) earned beyond compensation for risk
The comment by trying my best is spot on. Where I think the value add is that we've reduced everything in these markets to alpha vs. beta, and factors almost fall somewhere in between based on who you work for (pods wouldn't openly admit value > growth as a source of alpha, SMs might say it IS their source of alpha). I think what it boils down to is the idea that 1) the best managers KNOW down to the core where the risk in their book is, factors alike and 2) most PMs have some sort of implicit factor overlay or "tilt" in their book, so therefore perhaps it can be constituted as alpha.
Bit of a side note rant but I genuinely think people have essentially grouped stocks into factors because they're unwilling to do the work on identifying real "alpha" (change in narrative, inflection point in numbers, business/market change) and so being given the answers of what stocks are "quality" or "defensive" is an easy way to express a macro view. That + passive investing essentially giving everyone the adequate tools to know those exposures has a pretty large impact on the factor moves as well. But at the L/S level... I find it to be odd how many folks nowadays just say "oh that's a good company" or "that's a shitty company" with nothing to back it up besides what "factor" they know that name to be associated with. I largely think timing is very hard but per the post above risk is the price for reward - logically it makes sense that quality/defensive factors outperform in periods of macro uncertainty HOWEVER I don't think it is very fundamental in nature to immediately crowd into these factor tilts upon a change in the macro tide. So whatever alpha exists in timing the factors is probably limited over time due to crowding but agree that someone essentially being compensated in excess returns over their per unit risk is alpha.
Single managers are literally paid to take factor bets
To your question specifically, factor timing is fundamentally not a source of alpha. Alpha is (according to the Fama-French or whatever other paradigm) the residual error term after accounting for a security’s weighting on factors like broad market beta, sector beta, momentum, SI, value, size, etc. One can absolutely get paid good money to take factor-oriented bets, but anyone calling that alpha is misled. If you think growth is gonna outperform value or whatever, there’s literally thousands of ways to express that, and the specific fundamental stock-picking would matter very little in that thesis playing out effectively.
No. Factor timing IS alpha, by definition. You're correct that alpha is the residual return after accounting for factor weights. Thing is, the return earned by factor timing would be a residual return.
Take the simplest of examples - let's say the value factor rises steadily throughout the year, but has a sudden, big crash in July, but continues rising after that. The crash knocks value's returns heavily to let's say 5%. Say a PM who can theoretically factor time, he for whatever reason predicts that value will crash in July. So he longs value Jan - June, gets out before July, gets back in after the crash. His return is let's say 20%. He's now earned a residual return relative to his factor bet of 15%. Why? Factor timing. Alpha - driven by skill or luck. By definition.
Ofc this is all speaking in theory. Pretty sure no one can do what I just described - that's why it's called a risk factor. You must tank the risk to earn the premium, no cutting corners, and the fact that it's rlly difficult to hold onto is why it hasn't been arbitraged away
Ofc, but just taking factor bets isn't factor timing. That's just seeking exposure to alternative beta, no one called that alpha.
I disagree with you and agree with the other poster.
Beta is the most obvious/discussed factor. You can make money by being skilled at timing beta but that return is by definition not alpha. It is outperformance driven by skill. But it is not, strictly speaking alpha.
You can make the same argument for any factor.
Dolores ipsam enim illum laboriosam. Nisi odit ipsam harum illo ipsum iste quod. Sapiente excepturi veritatis ut quae repellendus nam voluptates. Aut qui animi iusto eos.
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