Smart Beta Equity Investing Through Calm and Storm

Smart beta portfolios typically achieve a superior diversification than the benchmark market capitalization-weighted portfolio, but remain vulnerable to broad market downturns. We examine tactical investment decision rules to switch timely between equity and cash investments based on an underlying regime switching model with macroeconomic, macrofinancial and price momentum variables as drivers for the time-varying transition probabilities. A regression-based method is applied to select the relevant state variables. An extensive out-of-sample evaluation for the S&P 500 stocks over the period 1991-2014 shows the gains of smart beta portfolios, the usage of time-varying transition probabilities and the requirement that the expected return should exceed the time-varying threshold implied by a forward-looking extension of Faber's market timing strategy. The resulting investment decisions are more reactive to changes in the market conditions, tend to avoid equity investment in bearish market conditions and have a substantially better risk-adjusted performance and lower drawdowns.