The Dynamic Duo Of Risk Factors: Part II

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Last week’s post on analyzing US equity value and momentum risk premia ended with a question: How much, if any, improvement should we expect by adding a dynamic system for managing exposure to these risk factors vs. a buy-and-hold strategy? What follows is a preliminary effort in searching for an answer. As a preview, the results are mixed, but this may be an artifact of a) focusing on value and momentum factors within the US equity space;b) using a specific definition of value and momentum (via Professor Ken French’s data library), which merely scratches the surface for modeling possibilities; and c) applying a simple tactical model that may be responsive to parameter changes for enhancing results.

Let’s start by comparing the momentum and value factors separately, in two flavors: a buy-and-hold (BH) strategy and a tactical strategy. Tactical asset allocation has endless variations, but it’s become standard in recent years to use Meb Faber’s widely cited model —“A Quantitative Approach to Tactical Asset Allocation”–as a benchmark. The original 2007 paper studied the results of applying a simple system of moving averages across asset classes. The impressive results are generated by a model that compares the current end-of-month price to a 10-month average. If the end-of-month price is above the 10-month average, buy or continue to hold the asset. Otherwise, sell or hold cash for the asset’s share of the portfolio. The result? A remarkably strong return for the Faber TAA model over decades, in both absolute and risk-adjusted terms, vs. buying and holding the same mix of assets. But as we’ll see, replicating these results for a US equity set of value and momentum premia can get messy.

Here’s how the US equity value premium stacks up as a BH strategy vs. a tactical model across the decades. Note the BH results tend to have an edge, which goes into overdrive for the ~20 years through the first half of the 1990s. But it all comes apart in the 21st century as BH stumbles sharply vs. a tactical approach.