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

 

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.

 

Factor Rotation

If switching between positive and negative sides seems underwhelming in comparison to just holding the positive side of the factor passively, what about the prospects of rotating between different positive sides?

Below we plot the growth of (1) a factor rotation strategy that rebalances monthly using 12-1 momentum to buy the top-three-performing factors equally; (2) a portfolio that equally weights the factors; and (3) the market.

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

What we can see is that momentum-based factor rotation not only beats the market, it also beats a passive, diversified factor portfolio.

Yet once again, the “long-term” may distort the picture. The factor rotation strategy only outperforms the equal-weight factor portfolio by 1.32% per year. If we consider manager costs and transaction costs in the equation (estimating, again, an all-in cost of 0.85%), this relative outperformance falls to 0.47%.

 

Again, nothing to scoff at, but we should also look at the ride we must take for it.

 

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

The long-term positive trend contains significant periods of underperformance and prolonged drawdowns. For example, after terrific relative performance from 1/1972 to 11/1980, the factor rotation strategy goes through a five-year drawdown.

From 1/1994 to 11/1999, the strategy was again underwater. After finally making rapid new relative highs, the approach peaked in 2/2000 and cratered during the dot-com bust. In fact, from 2/2000 to 1/2001, the rotation strategy underperformed the passive strategy by 15 percentage points, and failed to breach its relative highs again until 1/2009.

Mind you, none of this analysis takes fees into account, which would make these drawdowns both longer and deeper.

So yes, we believe factor rotation is a possible and valid strategy. The question we must ask ourselves is: “Is the post-fee potential high enough to justify the short-term headache?”

 

Conclusion

We believe there is conclusive evidence that factor rotation can be an effective means of improving upon passive buy-and-hold multifactor portfolios.

Between factor switching and multifactor rotation, we believe that rotation shows more promise. In our hypothetical example, rotation generated an excess return of 1.32% per year compared to the benchmark multifactor portfolio.

That said, in the real world, the marginal performance benefit may be quickly eroded after management fees, transaction costs and taxes are considered.

Above all, we believe investors should consider whether the potential benefits of factor rotation justify the potential anxiety of multiyear drawdowns against a passive buy-and-hold portfolio. After all, the optimal investment portfolio is, first and foremost, the one we can stick with.

Newfound Research LLC does not hold any of the ETFs referenced. The company is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research, call us at 617-531-9773, visit us at www.thinknewfound.com or email us at [email protected]. For a list of relevant disclosures, click here.

 

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