Macro-Finance and Factor Timing: Time-Varying Factor Risk and Price of Risk Premiums

Abstract

This paper documents empirically that increases in the book-to-market spread predict larger market premiums in sample and larger size, value, and investment premiums (also) out of sample. In addition, increases in the investment (or profitability) spread exclusively predict larger investment (or profitability) premiums. This predictability generates "factor timing" strategies that deliver substantial economic gains out of sample. I argue theoretically that the book-to-market spread is a price of risk proxy, while the investment and profitability spreads are factor risk proxies. The evidence confirms standard theoretical predictions in the macro-finance literature and contradicts the hypothesis of constant factor risks.JEL Codes: G11, G12, G14. These strategies are a type of "managed portfolio", described in Cochrane (2005), in which the wealth allocated to portfolio factors, such as the ones in Fama and French (2015), changes over time according to a given signal that forecasts the factor premiums. 3 The evidence in Section 3.2 is consistent with the hypothesis that, from a portfolio perspective, the profitability factor becomes safer as the BM spread increases, which could explain the lack of predictability.