Factor Rotation Is Possible, But Is It Worth It?

December 30, 2016

The danger here is our timing must be good enough to overcome the negative drag created when we occasionally pivot into the “negative side” of the factor. Using a simple 12-1 momentum approach (buy the side of the factor that has done the best over the prior 12 months, ignoring the most recent month), we can see that switching can overcome this negative drag to outperform the market.

Data Source: Kenneth French Data Library. Calculations by Newfound Research. Past performance is not a guarantee of future returns.

The problem here is that the market is a misleading benchmark. What we should be benchmarking against is the positive side of the factor, i.e., can switching do better than just holding the factor passively?

The answer there is far less convincing.

Data Source: Kenneth French Data Library. Calculations by Newfound Research. Past performance is not a guarantee of future returns.

Switching between large-cap and small-cap is the only approach that has convincingly beat just holding small-cap over the long run.

That said, the approach only outperformed by 1.69% per year. If you assume that accessing this strategy would require an active management fee of 0.75% and trading costs of 0.10% per year, this drops to 0.84% per year. Still nothing to scoff at, but when you consider that the approach has been in a relative drawdown to the passive small-cap buy-and-hold since 1999, you start to wonder if it is worth it.

 

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