On the Expected Performance of Market Timing Strategies

Abstract

We derive expressions for the Information Ratio (IR) that can be expected from directional market timing strategies. Our results hold as accurate approximations and lift Grinold’s [1989] “Fundamental Law of Active Management” to an operational level. In addition, we separate “time series breadth” (the timing frequency per strategy) from “cross-section breadth” (the number of separate markets) because they contribute differently to performance. We show that implementing volatility-weighted bet sizes, both in the time series context of a single underlying market and in the cross-section context of multiple markets, increases the expected timing IR. Our theoretical results can be used as a benchmark for and reality check on the back-tested performance of timing strategies. We confirm the accuracy of our results by simulating timing strategies for equities and fixed income.