Investing in Size and Book-to-Market Portfolios Using Information About the Macroeconomy: Some New Trading Rules

We propose new trading strategies that invest in size and book-to-market (B/M) decile portfolios. These trading strategies are based on a forecast model that uses mainly business cycle-related variables as predictors. Extensive out-of-sample experiments show profitable predictability in the returns of the decile portfolios. In particular, the proposed strategies outperform passive investments in the same deciles, as well as SMB- and HML-type of strategies. A key characteristic of the proposed strategies is that the long and short positions can be invested in different decile portfolios across time. This is in contrast to the traditional SMB- and HML-type of strategies that always go long and short on the same portfolios. Active strategies that involve the market portfolio, SMB and HML are also examined. A significant level of predictability is identified for SMB. Our results suggest that time variation in SMB and HML is linked to variations in aggregate, macroeconomic, nodiversifiable risk. Thus, our results most closely support a risk-based explanation for SMB and HML.