The economic benefits of market timing the style allocation of characteristic-based portfolios

• We confirm time-variation in relative performance of characteristic-based portfolios.
• Dynamic style portfolios are proposed to exploit time-variation in performance.
• Mean-variance efficiency properties are studied both theoretically and empirically.
• Empirical study confirms economic benefits in market timing the style allocation.
• Dynamic style portfolios outperform traditional stock-based allocation.

Many exchange traded funds track simple characteristic-based equity portfolios such as the market capitalization, the fundamental value or the inverse volatility portfolio. This paper provides theoretical and empirical evidence for the economic benefits in exploiting the timing-gains that result from the time-varying relative performance of these characteristic-based portfolios. Under a factor model for expected returns, we show that this dynamic portfolio allocation can be efficient across the low-dimensional set of characteristic-based portfolios. We assess the out-of-sample performance on the S&P 100 universe over the period 1990–2013 and show gains in stability and significant positive risk-adjusted returns for the dynamic style portfolio. We conduct several robustness tests and extensions confirming the benefits of dynamic style allocation across characteristic-based portfolios.