Factor Rotation Is Possible, But Is It Worth It?

December 30, 2016

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Corey Hoffstein, co-founder and chief investment strategist of Boston-based Newfound Research.

While research has generally supported that systematic momentum and value tilts applied to multifactor portfolios can generate excess risk-adjusted returns, the benefits do not come without the potential introduction of significant tracking error.

With the expectation that we will see more factor rotation strategies in the market in 2017, we think it is important to evaluate the magnitude of this potential trade-off.

Factor Switching
The first type of rotation we want to explore is factor switching. Traditionally, factors define a systematic process of bifurcating securities into a group expected to outperform and a group expected to underperform. For example, the value factor identifies that cheap stocks should outperform, while expensive stocks should underperform.

We call the group expected to outperform the positive side, while the group expected to underperform the negative side, to correspond with the expected positive and negative premiums associated with holding those portfolios.

The idea behind factor switching is that while the positive side may have a long-run positive expected premium, there are short-run periods where the negative side can significantly outperform.

For example, cheap stocks dramatically underperformed expensive stocks during the dot-com bubble. Small-caps significantly underperformed their large-cap peers during the final throes of the 2008 credit crisis.

Factor switching is all about timing these changes.

  Positive Side Negative Side
Value Cheap Expensive
Size Small Large
Operating Profitability High Low
Reinvestment Low High
Momentum Winners Losers
Beta Low Volatility High Beta

 

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