Can Short-Term Strategy Diversification Improve Market Performance?

In this whitepaper, AQR Capital, a quantitative trading firm, highlights why adding short-term momentum strategies to longer term contrarian valuation strategies to a broad based multi-asset portfolio may improve performance.

In light of the statistical evidence that valuation ratios forecast subsequent long-horizon returns, this paper examines the performance of market timing strategies based on these same valuation ratios. It finds that while contrarian market timing has outperformed buy-and-hold over the past 115 years, it has underperformed in the latter half of the sample (a very long time!) and generally looks weaker than many might expect. This paper explores why, despite seemingly strong in-sample statistical evidence, contrarian market timing has underperformed over the past six decades. First, we show that drifting valuations have made recent decades a particularly challenging period for contrarian timing that is unlikely to be repeated. Second and more importantly, we show that contrarian timing strategies are fighting the successful shorter-term momentum strategy.

We propose that by adding a dose of momentum, one can improve the risk-adjusted performance of contrarian market timing strategies. In fact, a naïve reading of the historical experience suggests using mostly or even only momentum-based timing, but diversification logic and more careful empirical analysis supports combining both contrarian and momentum indicators to make modest market timing tilts.

Skilled managers who add different layers of quantitative investment strategies to a broad based basket of uncorrelated investment assets will necessarily improve risk-adjusted returns.

READ THE PAPER