20216 PDFs viewer q The Journal , “Larthoki iO ‘N Janagement Defensive Factor Timing Kristin Fergis, Katelyn Gallagher, Philip Hodges and Ked Hogan JPM 2019, 45 (3) 50-68 doi: https:/doi.org/10.3905 /pm.2019.45.3.050 http://jpm.iijournals.com/content/45/3/50 This information is current as of March 17, 2019. Email Alerts — Receive free email-alerts when new articles cite this article. Sign up at http:/pm.iijournals.convalerts Institutional Investor Journals 1120 Avenue of the Americas, 6th floor, ww York, NY 10036, Phone: 2-224-3589 2017 Institutional Investor LLC. All Rights Reserved Downloaded from hip/pen journals conv by guest on March 17, 2019 hitps:ischolarchongbuluo.com ‘2020216 KRISTIN FERGIS BlackRock, Inc, in New York, NY. ‘stinergis@bacrock.com KKATELYN GALLAGHER isa director at BlackRock, Ine, im Now York, NY. ‘stem gllagherDheckroekom Prauie Hopcrs isa managing director ar BlackRock, Ine. in San Francisco, CA, Pp des @blakrehcom, KED HocaN isa managing director at BlackRock, Inc, in San Francisco, CA, JeLnganhlacrockcom 50 hitps:ischolarchongbuluo.com PDFs viewer Defensive Factor Timing KRISTIN FERGIS, KATELYN GALLAGHER, Puitie Hopces, AND KED HOGAN, well-balanced strategic allocation to factors, or asset elasses, is the foundation of a well-constructed long-term portfolio. However, factor premiums vary over time. There are three possible approaches that inves- tors could take in response to time-varying factor returns. The first approach i to ignore the short-term variation—since Markowitz (1952), we have built strategic allocations to access sources of return that should be rewarded in the long run. Second, investors might develop a short-term predietion model that aims to generate excess returns by tac~ tically changing positions around strategic factor weights (eg, Hodges et al. 2017). & disadvantage of this approach is that it may lead to short-term underperformance rela- tive to the strategic allocation, and those risks may increase with the frequency and size of the tactical decisions. The third approach is (© practice defensive timing: to recognize that during certain periods, it may be appro- priate to reduce risks to certain factors or across a portiolio with an aim co preserve capital during bad market regimes. In this article, we explore this third approach to defensive factor timing. Defen- sive factor timing focuses on mitigating the magnitude of losses by periodically reducing risk, as opposed to aiming to ourper- form a strategic benchmark by continually over- or underweighting different factors Duvasarvu Faerie Tote Put another way, defensive timing focuses on risk mitigation, which manages second and higher moments, rather than on incremen- tally increasing returns, which targets the first moment. The risk reductions are taken infrequently and only for those factors that are very expensive or offer few diversifica- tion benefits. During periods when aggre~ gate market risk tolerance is unusually low, or correlations unusually high, it may also be appropriate to reduce risk for the total portfolio. To illustrate the concept of defensive factor timing, we work with a portfolio of macro factor exposures in a multiasset context: economic growth, real rates, inflation, credit, emerging markets, and liquidity. These fac- tors are rewarded macro risk premiums, and we define these factors so that, to the prac- tical extent possible, they maximize exposure to the underlying macroeconomic source of risk. Por example, nominal bondsare affected by changes in both real rates and inflation. An inflation factor portfolio goes long nom- inal bonds and short real bonds (linkers) to concentrate on only inflation-related com= ponents (or inflation breakevens). Both devel- oped market and emerging market equity has tended to perform strongly when the global economy is growing, but certain risks present in emerging market equities are either absent or minimal in developed market equities (ee, among many others, Harvey 1995). Thus, an Quavrnrariya recta sun 2019 Downloaded from htp/penijournalscony by guest on March 17, 201920216 emerging market factor would go long emerging market equity and short developed market equity to focus on the risks unique to emerging markets. We use three quantitative measures to defensively time factors: (I) a measure of aggregate risk tolerance, which intuitively captures the effect of flight to quality, or a rotation from risky to safer assets during times of stress (2) a diversification ratio, which captures a potential Cemporary reduction in diversification benefits; and (3) valuation ratios of each factor. We discuss how defensive timing can be imple- mented using these metrics in a systematic investing framework and discuss case studies of risk reductions when these metrics have hit extreme levels, First, we investigate the European sovereign default crisis begin- ning in 2010 when Greece, Spain, and Portugal were sharply downgraded (and Greece eventually defaulted). After a brief period of recovery, fragility in Europe returned in 2012 when Greek officials admitted an exit from the Burozone was possible. Second, during the Taper Tantrum in May 2013, the Federal Reserve announced that it planned to wind down (taper) bond purchases, which caused a steep fall in government bond prices that spread to other asset classes. Finally, in the second half of 2015, there were concerns about slowing, Chinese growth and falling commodity prices. During each of these episodes, unattractive market conditions can be captured by the defensive indicators, potentially allowing portfolio managers to reduce risk allocations. Our article is related to two streams of literature. ‘The first is on factor timing and, more generally, market timing. Ferson and Harvey (1991) wrote a seminal paper in this literature, with more recent contributions made by Arnott et al. (2016), Asness 2016), and Hodges et al (2017). Our defensive factor timing framework is a form of factor timing, but it concentrates on mitigating risk as opposed to generating excess returns. There is also a voluminous risk management literature. Most of the papers in risk management focus on using signals and characteristics to monitor the risk of a given portfolio, rather than using inputs to make ex ante portfolio deci- sions. In one stream of the risk management literature, researchers such as Grossman and Zhou (1993) and Browne (1997) devised optimal strategies for managing downside risk—but they only used information from the return series of the portfolio as opposed to allowing investors to make defensive timing decisions using other fundamental information, Quaserneatove Sixcrat asus 2019 PDFs viewer After describing the macro factor setting, i the next section we describe a systematic framework for defensive factor timing using three signals: a risk tolerance indicator of aggregate market conditions, a measure capturing, the benefits of diversification, and valuation indicators for each factor. Finally we discuss historical case studies in which the applied. MACRO FACTORS Following the framework of Ross (1976), we sum- marize the movements of global asset class returns with common factors. These macro factors have three furda~ mental characteristics: (1) They help explain the majority of the variability in asset class returns; (2) historically, they have been rewarded over long-term horizons because of an undiversifiable risk premium; and (3) they are economically intuitive.' Put another way, the macro factors have broad effects and span several asset classes, and exposure to these factors has resulted in persistent risk premiums over the long run, Macro Factor Mimicking Portfolios Statistical approaches suggest using a parsimonious set of factors. We take a global portfolio of 14 major asset classes from April 2004 co December 2017.” As shown in Exhibit 1, the first three principal compo- nents explain 82% of the variation, and the explanatory power increases to 92% with six prineipal components. Although statistical principal components show that the ‘See Ang 2014) fora literature summary on factor investing, "The asset classes and representative indexes used are iked debt, Bloomberg Barclays World Gos nked Bond Index: developed sovereign deb, World Government Bond Index 7-10 Yr, investment-grade credit, Bloomberg Barclays Global Aggregate Corporate Index; emerging soverciga deb, JPMorgan Emerging Markets Bond Index Com- posite; high-yield credit, Bloomberg Barelays US Corporate High Yield Index; developed equity, MSC1 World Index: developed small-cap equity, MSCI Small Cap World Index; emerging equity, MSCI World EM Index; private equity, S&P Listed Private Equity Index; infrastructure, S&P Global Infrastructure Index; prop- crty, FTSE EPRA/NAREIT Global Real Estate Index; volatility, Chicago Board Options Exchange Volatility Index; and commodi- tics, Bloomberg Ex-Encrgy Snbindex Total Return and Bloomber, Energy Subindex Total Retarn, Principal components analysis is done on the correlation matrix. Tus}ivanavie Poston Mascon Si Downloaded from htp/penijournalscony by guest on March 17, 2019 hitps:ischolarchongbuluo.com 312020216 EXHIBIT 1 PDFs viewer Principal Component Decomposition of Global Asset Classes 100% om PCL PC? «PCS Ped PCs: global asset class returns data can be represented by a small number of factors, it has litle to say beyond the fact that we need only model a few underlying factors. To move toa tradeable representation of a small number of factors based on economic rationale, we follow Chen, Roll, and Ross (1986) and choose to work with macro factors as shown in Exhibit 2. ‘These macro factors are intuitive and have been the focus of many in the literature. For example, eco- nomic growth is the foundation of consumption-based asset pricing and real business eycle models (ee, among, many others, Lucas 1978). Policymakers treat separately the effects of real rates and inflation (Taylor 1993) and assign a role to credit in channeling monetary policy (Bernanke and Gertler 1995), We form each of the macro factors to be a hypo- thetical long-short portfolio to maximize exposure to the underlying macro factor. This is especially impor- tant for emerging markets, which have significant cor- relations with developed markets, but there are specific risks for emerging markets in excess of their exposure to developed equity Gee Bekaert and Harvey 2003), and the liquidity factor because illiquidity risk increases during market downturns (see Amihud, Mendelson, and Pedersen 2008). 52 Darsiaeva Factoe Tue Economic Intuition for Hypothetical Macro Factor Portfolios In Exhibit 3, we show that these hypothetical macro factor portfolios—economic growth, real rates inflation, credit, emerging markets, and liquidity—each capture a fundamental risk premium and are constructed so as to provide relatively clean exposure to the under- lying premium. Exhibit 3 compares the realized returns of the economic growth, real rates, and inflation trade able factor portfolios with the respective underlying ‘economic phenomena, Panel A graphs gross domestic product (GDP) sur- prises, calculated as the difference between realized GDP and GDP expectations, sourced from Consensus Economics survey forecasts. The correlation between the series from 1997 to 2017 is 0.6. The premiums investors expect from economic growth reflects compensation for bearing the risk that GDP will slow below expectations. For example, during the financial crisis of 2008, realized GDP was sig nificantly under expectations. During this time, we see the economic factor track the decline in GDP with losses in developed equities, commodities, and listed real estate In Panel B of Exhibit 3, we show returns of the real rates factor (which is the difference in returns between real gowe thonds and cash rates) and surprises in real yielc Quavrnrariya recta sun 2019 Downloaded ftom htp:/jpm ijournals.comy by guest on March 17, 2019 hitps:ischolarchongbuluo.com 412020216 PDFs viewer EXHIBIT 2 “Macroeconomic Factor Definitions Factor Economie Rationale Factor Mimicking Portfolio [Bconoosic | Renard forvaking expose tthe global economy | Longe Egy Sires lite el ent (elena invartnest nas), Growth commodien Short: Cash Reales | Reward foriaking exposure fo thevik ofmovements | Long: Basket of sovereign inlatonlinked bonds in interest tes Shot: Cash Tnfiston | Reward fortaking exposure to canges in aises Tong: Bask ofsominal sovereign Boods Short: __ Basket of nfationlinked sovereigns of matching matrity Gretit [Reward fr lending to eoxportions rather than Long: Investment-grade bonds high-yield bonds goverment Short: __ Government bonds Emerging | Renard forvaking expanse tothe addonl poitial | Long Emerping made ein ering mates det Markets | sik rm emerging markets Short: Developed marke equity: developed government bonds Liquidity | Reward for taking exposure to liquid ase TLoag: Smalhcap equity Short:__Large-capesuty, volatility ures Noes: Frills purposes only using hyporeral ftos ond epee of ca eset ov acount. As of fe 30,2018 ‘The surprises in real yields on the left-hand side of the chart are sorted in reverse order to illustrate that when yields surprise on the downside, we expect both real bonds and the real rates factor to deliver a positive return. The cor relation between these two series is 0.8. There isa notable negative surprise in real yields in 2009, which corresponds {o rising real bonds during the recovery from the financial crisis. There is a large positive real yield surprise in 2013, when Federal Reserve Chair Ben Bernanke surprised bond markets by announcing a decrease in large-scale bond pur- chases, effectively winding down the quantitative easing program that had been in place since 2008, This coincides with one of the worst years for the real rates factor, which falls when real rates rise more than expected We construct the inflation factor as the difference between a portfolio of nominal government bonds and inflation-protected bonds. This factor has tended to deliver positive returns when realized inflation falls below expectations, as Panel C illustrates. For example, inflation expectations fallin the financial crisis of 2008, and traditional safe havens such as US Treasuries rise faster than their inflation-linked counterparts; con- sequently, the inflation factor rises significantly, cap- turing the downside inflation surprise. The correlation between the inflation factor and inflation surprises is 0.9 over 1997 to 2017, Having demonstrated that these macro factor portfolios are good proxies for the underlying eco- nomic risks, we now illustrate how an investor holding, Quaserneatove Sixcrat asus 2019 4 portfolio exposed to these macro factors may be able to defensively time the factor exposures using various indicators. INDICATORS FOR DEFENSIVE FACTOR TIMING ‘We start with a robust strategic multifactor port- folio that is deliberately diversified across the underlying drivers of asset class returns. The simplest approach is to allocate an equal amount of risk to each factor portfolio. Investors with unique investment goals, such as higher returns or reduced risk, can adjust the factor weights to meet those bespoke requirements, as discussed by Bass, Gladstone, and Ang (2017), For the purposes of this article, we use a hypo- thetical strategic factor allocation constructed such that 30% of the risk is attributable to economic growth and 30% to real rates, and the remaining 40% is driven by an equally weighted combination of inflation, credit, ‘emerging markets, and liquidity. The total portfolio is scaled to have an unconditional volatility of 10%. By upweighting economic growth, the investor has a higher exposure to a factor that historically has had larger long-term Sharpe ratios than the other factors; similarly, the investor benefits from higher exposure to real rates, which have tended to do well when policymakers seek to lower real rates below expecta tions to stimulate economic growth during bad times 53 Th Jouknas o# Poets Masacnens Downloaded from htp/penijournalscony by guest on March 17, 2019 hitps:ischolarchongbuluo.com 512020216 PDFs viewer (ee Exhibit 3). Our systematic approach to defensive Risk Tolerance Indicator factor timing seeks to deviate from this diversified strategic factor allocation and targeted volatility when ‘we observe extremes in risk aversion, correlations, or valuations. We now describe each of these indicators separately, Under normal economic conditions, we expect assets to be priced such that expected returns are a posi tive funetion of asset riskiness: The higher the risk of anasset, the higher the expected return, and vice versa. EXHIBIT 3 Relating Macro Factors to Economic Shocks Panel A: Economic Growth Factor and Surprises in Economie Growth 2% % 0% i i 6 GDP Suprise (LHS) —— Eeononile Factor Reta (RES) Panel B: Real Rates Factor and Surprises in Real Rates “ie sor “10% we f . z A : . om . a 7 Love Whe PS BREE EER ERG amMaeseR™ ERR RRR RRRRRRRRRRAR ER Real Yield Surprise (LHS) Real Rates Factor Retum (RHS) Downloaded from htp/penijournalscony by guest on March 17, 2019 hitps:ischolarchongbuluo.com20216 EXHIBIT 3° (continued) Relating Macro Factors to Economic Shocks PDFs viewer Pane! C:Tnflation Factor and Surprises in Taflacion 20% 15% 10% g E-05% 00% 05% 10% 13% z 2008 2004 2005 2007 60% Inflation Factor Return 20% gece < ER ERRERRE allan Suprise (LHS) Taflaton Factor Retom (RES) Notes Pat porfnmance i nt indzatve af fate recut. Retures donot acount for any fies ortamscton crt. If fies mere include, return would be lower For ilshatve purposes only using hypothetical factors and no eprsematv of an atua investment or acnt. The modeled performance is cal ‘ulated wit the hoof of hindigh and anowledge of factors that may have ostivly acted ie perfomance and has inherent lintations. This analyse cannot acconnt for risk factors that may act actual pono performance However, during periods of low risk tolerance, the positive correlation between risk and return can turn negative: When investors panic, they tend to flee from risk assets, driving down the price while bidding up the price of safer assets. During these periods of extreme negative sentiment, even well-diversified portfolios can suffer sharp negative returns as market dynamics break down and investors are penalized for holding risky assets,” “The risk tolerance indicator (TI) aims to identify such low-frequency, high-loss periods ex ante. Let q(R') denote the ranking of asset i by return, and let 4(6,) Schwert There isa substantial literature following, French, and Stambaugh (1987), documenting a pronounced contempora- neous native correlation between realized returns and volatility, ‘which we capture in the RTI. The relation between expected returns and volatility is much harder to pin down empirieally but should theoretically be positive over most of the range of volatility (Gee Ang and Liv 2007). Quaserneatove Sixcrat asus 2019 denote the ranking by risk. The RTI is then calculated as the correlation between the two rank vectors:' RTI= con q(R,),4(6,)] ‘Typically, positive RTIs accompany periods of increasingly positive investor sentiment, or risk-on environments, whereas periods of declining investor sentiment, often coinciding with a flight to quality, will see a negative RTI, Investor sentiment tends to per- sist, so rising (falling) investor sentiment usually leads “Note that we could alo have defined the RTI equal to the correlations between the quantities themselves. Taking ranks allows the indicator tobe applicable to asset pricing models that have anon- linear dependence between risk and expected return and prevents the dominance of exte ne values. Rank statisties are commonly al inference. For well-behaved, especially ‘shite difference between wsing Pearson correlations on raw series vers Spearman rank correli= tions—see, for example, Haber (1981) A similar rank correlation imeasure is computed by Kumar and Persad (2002) to asses sent ‘ment in the equity market TuvJousnaior Porvona Manaceuans 55 Downloaded from htp/penijournalscony by guest on March 17, 2019 hitps:ischolarchongbuluo.com 712020216 EXHIBIT 4 Risk Tolerance Indicator 100% 188 50% lerance Indientor 9% 2 -s0%6 5% 100% 2006 2007 2008 2009 2010 201 2 Rink Tolerance Indiator (LHS) —— PDFs viewer 30% 2 2013 2014 2015 2016 2017 2018 Rolling [-¥e Return MSCI Word Index (hedged) (RHS) Notes: dees ae managed, and is mot posi to inves directly ian inde. Past performance i nota uaante of fare esas, to a further increase (decrease) in investor sentiment. Under these conditions, our strategy of bearing system- atic risk is susceptible to drawdowns; the size of these drawdowns depends on the extent of the risk aversion. When the RTI reaches extreme negative levels, we can scale down, pro rata, the exposure of our strategic multifactor portfolio while remaining invested across asset classes. ‘We compute the RTI using rolling three-month periods, with weekly return frequency data, for the 14 asset classes and graph the statistic in Exhibit 4. In this exhibit we also overlay rolling one-year returns of hedged MSCI World equities. (The correlation between the RTI and developed equity returns is 0.6.) When equity returns fall and investors demand safer assets im a risk-off environment, such as in 2008, 2011, and, more recently, che first quarter of 2018, we see a commensu- rate decline in the RTT. By construction, the RTI falls most sharply when correlations between risky and safe assets fall toward —1, when the rotation from risky assets, to safe havens is most severe. Such an episode happens in 2008, 56 Durasarva Faeroe Tne Diversification Ratio While the RTI measures the relation between assets’ risk and returns, during bad times the correlations between assets can also change. In particular, diversifica- tion can become less effective, To capture these effects, ‘we include the diversification ratio as a measure of port- folio concentration Diversification Ratio where w, and 6, are the weight and risk of asset i, and 6, is the risk of the portfolio. To calculate volatilities, we use a short-term, 21-day risk model, A high diversification ratio indicates that the portfolio’s risk is substantially less than the sum of the risks of the individual assets and, as such, that the port= folio benefits from significant diversification. As correla- tions increase, the diversification ratio decreases toward one, signifying diminishing diversification benefits in the portfolio. Periods when the diversification ratio Quavrnrariya recta sun 2019 Downloaded from htp/penijournalscony by guest on March 17, 2019 hitps:ischolarchongbuluo.com 812020216 EXHIBIT 5 Diversification Ratio 33 1s is 2006 2007 2008 2009 2010 2011 2012 2013 PDF js viewsr 20% 13% 10% 3% ; i o% % 10% -15% 2014 2015 2016 2017 Diversification Ratio (CHS) Rolling 1-¥+ Return 20/80 (RES) Notes: The 20/80 pot represented by MS 1 Wid Index (hedge) and Bloomberg Barclays Global Aggigte Index (hedge, respectively. Indes are unmanaged, and it 5 not possible to inves diet ina ind, Past pexformance is mot aguante offre resus is low tend to correspond with periods of significant market stress, when tail risks are elevated. By construction, our strategic multifactor port- folio seeks to maximize diversification by balancing risk across historically rewarded macroeconomic fac- tots, so it is vulnerable to correlation spikes that reduce the benefits of diversification. A short-term measure of portfolio diversification could serve as an indicator for reducing portfolio risk against a background of increasing correlations. Exhibit 5 illustrates historic diversification ratios against the rolling one-year return of a 20/80 stock/ bond portfolio, consisting of 20% MSCI World Index (hedged) and 8% Bloomberg Barclays Global Aggregate Index (hedged). We use a 20/80 portfolio to represent a simple multiasset portfolio with balanced equity and interest rate risks, which normally benefits from diver sification. The Taper Tantrum of 2013 is an extreme episode of deteriorating diversification benefits, when correlations between equities and bonds spike toward one. In Exhibit 5 we see the diversification ratio and the 20/80 portfolio decline in tandem. It is worth noting Quaserneatove Sixcrat asus 2019 that during 2013 when the diversification ratio decreases, the RTI remains broadly positive (sce Exhibit 4), illus trating the benefit of having multiple defensive timing indicators, Valuation Indicators Factors, like all investments, become richer or cheaper compared to their historical long-term averages. We construct factor valuation indicators to measure their prices relative to intrinsic value. Each macro premium is aggregated and smoothed over time to produce a mea sure of how the valuation of the factor compares to its ‘own history. A positive valuation score indicates cheap- ness, and a negative score indicates richness. A factor is fairly valued compared to its own historical long-term average when its valuation score is zero. The time- series scoring also adjusts for long-term risk premiums ‘embedded in each factor. We describe our valuation methodology for each factor. Economic growth. We use a variant of Shiller’ cyclically adjusted price-to-earnings ratio (CAPE) TusJounnat or Poervons Manacewnre 57 Downloaded from hitp/pen.ijousnals com by guest on March 17, 2019. hitps:ischolarchongbuluo.com20216 (Gee Campbell and Shiller 1988) as the valuation indicator for economic risk because it measures the price of equity markets relative to real earnings. Specifically, we build a market-cap-weighted global CAPE using data from individual countries and then take the inverse to produce an earnings yield. We also look at the difference between the earnings yield and bond yields as a measure of the economic risk premium, Real rates. Since Solow (1956), many authors have linked the equilibrium real rate in the economy to econoinic growth and other preference parameters of a representative agent. In these formulations, the real rate is the rate consistent with economic growth matching potential without accelerating inflation. Real rates embedded in real bonds, however, can differ because of risk premiums and the action of policymakers, Never theless, we use the motivation of these economic anchors to look across various developed-market economies at how real interest rates compare to expected GDP growth to determine the valuation of the real rates factor. Inflation, We measure the valuation of the infla- tion premium by comparing market-implied breakeven inflation, based on five-year government bonds, with expected inflation, which we proxy with a combination of survey inflation expectations and trailing realized inflation Gredit. Consistent with Merton (1974), who showed that credit spreads must compensate investors for expected defaults, we measure the valuation of credit risk as the difference between the current credit spread and the loss given default, calculated using a combination of historical data and economic intuition. We calculate this premium across both investment-grade and high-yield credit, tor both the United States and Europe Emerging markets. We measure the emerging, ‘markets risk premium using both equity and bond valu- ations. For equities, we compare the Shiller earnings yields and dividend yields of emerging and developed market countries. For bonds, we compare the current spread of emerging market debt over US Treasuries to its long-term average. Additionally, following Harvey (1995) and others, we use regression-based analysis on various political risk indicators to calculate the marginal price of political risk, which indicates whether polit- ical risk in the marketplace is being priced to earn a premium, Liquidity. The liquidity valuation indicator accounts for both strategies that compose the factor: the 38 DarunaveFacros Thane PDFs viewer small-minus-big effect Gee Banz 1981) and volatility selling (Bakshi and Kapadia 2003). For the small-stock component, we again use the Shiller earnings yield, this time comparing the earnings yields of small and large cap equities. The volatility selling component consists of two valuation measures: the carry implied by the VIX term structure and the ratio of the cur- rent price, spot VIX, to fundamental value, which we take as the short-term realized volatility of the S&P 500 Index Exhibit 6 provides the historical valuation levels for each factor, where the level corresponds to the valu- ation score, or number of standard deviations away from fair value, Scores below zero imply a factor is currently expensive relative to its history, and scores above zero suggest attractive valuations. Because interest rates have largely decreased since the 1970s (atleast until 2017), the real rates factor has a prolonged period of being over- valued (Panel A). Similarly, the inflation factor becomes very expensive after the financial erisisas flight to safety effects push up nominal bond prices (Panel B). Con- versely, the growth factor becomes cheap during the financial crisis because equity returns are significantly negative during that time (Panel D). Since the begin= ning of the equity bull market in 2009, multiple expan- sion drives prices higher, outpacing fundamentals, and the premium associated with economic growth declines in turn. EMPIRICAL RESULTS In this section, we evaluate the three defen- sive timing indicators—RTI, diversification ratio, and factor valuation indicators—across recent market environments. Philosophy of Defensive Factor Timing The goal of defensive factor timing is to protect capital against prolonged losses, it is not intended to icrement returns via tactical decisions. Therefore, we do not reduce the risk in our portfolio every time our signals indicate a negative outlook. Rather, the signals must indicate extreme levels of risk aversion, corre lation, or valuations, to warrant reducing risk. Some extreme positions might be represented by the indi- cators approaching, of breaching, plus or minus two QuavrnrariyaSreciat sun 2019 Downloaded from htp/penijournalscony by guest on March 17, 2019 hitps:ischolarchongbuluo.com 1012020216 EXHIBIT 6 PDF js viewsr Factor Valuation Scores Quaserneatove Sixcrat asus 2019 hitps:ischolarchongbuluo.com Panel A: Real Rates Factor ‘ as vi a4 usenet Chey 1 ° is a2 aes oP) 2 2006 2007 2008 2009 010 201 2012 2013 201 2015 2016 2017 2018 ‘Panel Bs Inflation Factor Estreuely Cheap Cheaper = <= Richer 2005 2007 2008 2009 2010 201L 2012 2013 2014 2015 2016 2017 2018 ane C: Credit Factor Cheaper > Real Rates Inilation credit Economie Emerging Liguidity Grom Markets ‘Range of Valuation Scores ===—~ Exuemely Rich ————~ Exwemely Cheap @ ApelD Panel B: Euro Criss 2012 8 6 4 Cheaper > Real Rates Inflation Credit Economie Emerging Liguiity Growth Markets ch ~—==- Extemely Cheap @ May-12 Exemely Range of Valuation Sees = (omtinued) Quanturateve Sncxat bss 2010 Thu Journanon Portoie Maxscusinr 63 Downloaded from htp/penijournalscony by guest on March 17, 2019 hitps:ischolarchongbuluo.com 1512020216 EXHIBIT 8 (continued) ‘Valuation Indicators during Case Study Periods Panel C: Taper Tantrum 2013 8 6 Cheaper => PDFs viewer 4 4 Real Rates Inflation creat Economic Emerging Liguisiry Growth Markets Range of Valuation Scores ===> Extremely Rich ~--=- Extremely @ Nays Panel D: China and Oil Concerns 2015 8 Cheaper > Richer Inflation eal Rats credit Economie Groth Emerging ‘Makes Liguidty Range of Valustion Sense = > Ensremely Rich = Extremely Cheap @ labs Iie: Fo ltsnive purposes ony sing hypothe factors and wot representative of an actwal investment or accu We plotthe drawdowns of the theoretical de-risked and the baseline portfolios during the period from May to September 2013 in Exhibit 9, Panel C. As both equi- ties and bonds fall, our pro rata reduction in risk, coupled 64 Davenaivn actos Tone with the scaling down of real rates exposure, mitigates losses in our de-risked factor portfolio: The maximum drawdown is ~7.3% versus -9.5% in the baseline port folio. This perfect-storm environment of heightened Quavrnrariya recta sun 2019 Downloaded from htp/penijournalscony by guest on March 17, 2019 hitps:ischolarchongbuluo.com 1612020216 PDF js viewsr EXHIBIT 9 ‘Drawdowns versus Baseline Portfolio during Case Study Periods ‘Panel A: Euro Crisis 2010 0% 1% 2% 3% 4 9% Mayl0 Janel Jal Aug-10 Sep-10 —— Baseline Factor Patfolio. —— De Risked Factor Portfolio ‘Panel B: Euro Crisis 2012 0.0% 10% “1% Jun dua Aug 12 — Baseline Foster Potolio — De Risked Faster Portfolio. Panel C: Taper Tantrum 2013 0% 6% 8% 10% ‘anel sues Angels Sepels —— Baseline Foctor Patfolio —— De-Riked Factor Portfolio (continued) Quaserneatove Sixcrat asus 2019 niJouksaLoePirrsis Mawacunshe 65 Downloaded from hitp/pen.ijousnals com by guest on March 17, 2019. hitps:ischolarchongbuluo.com 1712020216 EXHIBIT 9 (continued) PDFs viewer Drawdowns versus Baseline Portfolio during Case Study Periods ‘Panel D: China and Ofl Concerns 2018 oe Jaks Augels Notes: Past perfomance i not indicative af ature recut, Returns donot acount for amy ees or tamscton vst. Ife mere include, rtame would be lower. Forillshatve purposes only using «hypothetical macro factor porto amd wot epresemtativ ofan actual investment or econ. The modeled per fonmance i caledated with the benef of hinds and lowed of actors that may have psitely afd its performance and bs inherent Fitton. ‘This analysis cannot acount for vk factors that may aft actual penyolo performance. cross-asset correlations and broadly unchanged investor sentiment demonstrates the need for multiple, uncor- related indicators to effectively implement defensive factor timing, China and Oil Concerns 2015 Financial markets respond to three main sources, of uncertainty during the summer of 2015: China, Greece, and commodities. Throughout the month of July, Chinese equity markets remained highly volatile despite measures taken by authorities to stabilize prices, and commodities suffered intense liquidation pressure, led by oil. Greece dominated headlines after a negative vote on the terms of the bailout referendum on July 5. We see in Exhibit 7 the deterioration of investor senti- ment throughout July, as the RTI falls to ~43% by the end of the month. This rapid drop in the RTT again sig- nals defensive timing opportunity, and we reduce risk in our macro factor portfolio by 20%, (Note that at this time, there are no warning signs from the diversification ratio in Exhibit 7 or the factor valuations in Exhibit 8). ‘The RTI effectively signals in July what will become the worst month in financial markets since the financial crisis. During the month of August, with the 66 Dassnaivn actos Twa economic slowdown in China at the center of the market correction, commodity prices reach their lowest point since 2008, and the VIX Index spikes to more than 50, its highest level since the financial crisis. The RTT continues to spiral downward and ends the month of August at -60%. In October 2015, markets begin to nor malize as investors start to accept the reality ofa Chinese slowdown: upon this normalization we feel comfortable increasing portfolio risk back to normal levels. During the period between July and October 2015, the de-risked hypothetical portfolio has a subtly improved drawdown profile compared to the baseline portfolio, ~4.5% versus —5.5%, respectively, as illus trated in Exhibit 9, Panel D. Although the hypothetical portfolios have similar drawdown profiles at the start of the period, the improvement becomes more pro- nounced in late August and September at the peak of the market correction, when the RTI further deterio- rates to -80% CONCLUSION Defensive factor timing periodically, but infre~ quently, takes down risk exposures to a given factor or the full portfolio during adverse market conditions. This QuavrnrariyaSreciat sun 2019 Downloaded from htp/penijournalscony by guest on March 17, 2019 hitps:ischolarchongbuluo.com 18120