The Masters of Factor Timing

Look to newer, smaller hedge funds with high incentive fees for the most timing ability, researchers have claimed.

AQR Founder Cliff Asness has warned that factor timing is “very difficult to do well.” But some hedge fund managers may have the skill to pull it off, according to new research.

A study focusing on factor timing ability of more than 3,000 hedge funds from January 1994 to April 2014 concluded that managers as a whole “do possess factor timing skills,” with the most skillful hedge funds delivering alpha of 0.96% annually through factor timing.

These top-performing funds tended to be younger and smaller, have higher incentive fees, have a smaller restriction period, and make use of leverage, found Netherlands-based KAS Bank analyst Bart Osinga and finance professors Marc Schauten and Remco Zwinkels of the Vrije Universiteit Amsterdam.

“These funds are more flexible to engage in factor timing strategies due to the younger and smaller environment,” they wrote. “More flexible funds have better factor timing skills.”

Meanwhile, higher incentive fees and smaller restriction periods are likely to draw in more skillful managers, the authors argued.

“A shorter restriction period is preferable for investors,” they continued. “Thereby, funds with smaller restriction periods can theoretically attract more investors, which in turn can result in attracting higher skilled managers.”

Although skills varied across investment styles, the authors found managers overall possessed “strong” ability in timing market, size, and bond risk factors. The emerging markets factor, meanwhile, was the subject of “substantially negative timing”—a result they attributed to herding behavior.

“This study presents broad and strong evidence for the factor timing skills of hedge fund managers,” Osinga, Schauten, and Zwinkels concluded. “A better understanding of [these skills] is important for investors to make a better investment decision and important for the managers themselves to learn from.”

Read the full paper, “Timing is Money: The Factor Timing Ability of Hedge Fund Managers.”

Related: Don’t Try to Time Factors, Says Cliff Asness & A Factor Flap