australiaen
Factor investing challenges: factor timing

Factor investing challenges: factor timing

29-08-2017 | Factor investing challenges

Should investors try to time their exposure to different factors? Factor-based strategies have become increasingly popular in recent years. But how to implement them in practice still remains a puzzle for many newcomers. Deciding whether to tactically monitor and adjust exposures to different factors and, if so, how to go about it, is often raised as a major concern.

Speed read:

  • Individual factors can experience periods of disappointing performance
  • Factor timing is an ongoing debate
  • We recommend diversification unless one particular factor is of strategic interest

In recent years, the growing awareness regarding the benefits of strategic allocation to a number of well-rewarded factors has led increasing numbers of investors to consider this option. But while single factor-tilted portfolios have proven they can significantly outperform the market over the long term, they can also experience periods of disappointing performance relative to other single-factor portfolios and even to classic market-cap weighted benchmarks.

This phenomenon has been demonstrated extensively in the academic literature. In a recent paper , for example, Elroy Dimson, Paul Marsh and Mike Staunton noted that “a factor that is ranked high in performance in a particular year may remain high, may end up in the middle, or may slip to low in the following year”. Their research focused on five of the most commonly targeted factors: size, value, income, momentum and low volatility. For each of them, they presented detailed annual return figures recorded since the financial crisis, and ranked the factors from the best to the worst in terms of performance.

Periods of relative underperformance of single-factor portfolios can last for years, testing the patience of many asset owners. A FTSE Russell survey carried out in 2016 actually showed that deciding whether to tactically monitor and adjust exposures to different factors and, if so, how to go about it, ranked seventh among investor concerns when it comes to factor-oriented allocations.

Stay informed on Quant investing with monthly mail updates
Stay informed on Quant investing with monthly mail updates
Subscribe

To time, or not to time…

Academics and practitioners continue to debate this issue

Academics and practitioners continue to debate this issue and can be divided into roughly two opposing camps. The first of these assumes single factor performance can be forecasted relatively accurately and therefore advocates tactical factor timing, at least in moderation.

One popular timing approach is to look at the relative valuation of different single-factor portfolios. This usually involves analyzing classic measures of valuation, such as price-to-book or price-earnings ratios. The idea is to increase exposure to factors that trade at a discount compared to their historical norms, and to reduce exposure to those exhibiting high valuation multiples compared to their historical average.

The second group considers factor timing – not to mention general market timing – too difficult, and therefore not really worth the effort . Among other things, they argue that different measures of valuation often lead to conflicting conclusions. Moreover, they think that deciding factor exposure based mostly on its valuation is misguided, since some of the proven factors, such as momentum or quality for example, also typically clash with the value factor.

Benefit from factor investing
Benefit from factor investing
Discover the essentials of factor investing
Read more

Valuation is important

At Robeco, we agree more with the second approach. As a result, we usually recommend that our clients either opt for broad diversification across the different factors we exploit in our strategies, or for one particular factor of strategic interest, but bearing in mind they will be faced with short term underperformance.

This does not mean valuation should be ignored, on the contrary. As mentioned in a previous article in this series, investors should closely monitor their exposure to the well-established factors and make sure they avoid unintended factor biases.

This is also why the enhanced single-factor definitions, which are used in Robeco’s factor investing strategies, always take valuation criteria, among others, into account. That way, we can avoid buying stocks which are overpriced. This improves both the factor characteristics of our enhanced factor strategies and the efficiency of the exposures both in our single and multi-factor solutions.

1Factor-Based Investing: The Long-Term Evidence’, Elroy Dimson, Paul Marsh and Mike Staunton, Journal of Portfolio Management, 2017.

2My Factor Philippic’, Cliff Asness, 2016.

Factor investing challenges
Factor investing challenges

This series of articles aims to answer some of the key issues faced by investors when implementing factor investing strategies.

Read all articles
Logo

Disclaimer

BY CLICKING ON “I AGREE”, I DECLARE I AM A WHOLESALE CLIENT AS DEFINED IN THE CORPORATIONS ACT 2001.

What is a Wholesale Client?
A person or entity is a “wholesale client” if they satisfy the requirements of section 761G of the Corporations Act.
This commonly includes a person or entity:

  • who holds an Australian Financial Services License
  • who has or controls at least $10 million (and may include funds held by an associate or under a trust that the person manages)
  • that is a body regulated by APRA other than a trustee of:
    (i) a superannuation fund;
    (ii) an approved deposit fund;
    (iii) a pooled superannuation trust; or
    (iv) a public sector superannuation scheme.
    within the meaning of the Superannuation Industry (Supervision) Act 1993
  • that is a body registered under the Financial Corporations Act 1974.
  • that is a trustee of:
    (i) a superannuation fund; or
    (ii) an approved deposit fund; or
    (iii) a pooled superannuation trust; or
    (iv) a public sector superannuation scheme
    within the meaning of the Superannuation Industry (Supervision) Act 1993 and the fund, trust or scheme has net assets of at least $10 million.
  • that is a listed entity or a related body corporate of a listed entity
  • that is an exempt public authority
  • that is a body corporate, or an unincorporated body, that:
    (i) carries on a business of investment in financial products, interests in land or other investments; and
    (ii) for those purposes, invests funds received (directly or indirectly) following an offer or invitation to the public, within the meaning of section 82 of the Corporations Act 2001, the terms of which provided for the funds subscribed to be invested for those purposes.
  • that is a foreign entity which, if established or incorporated in Australia, would be covered by one of the preceding paragraphs.
I Disagree