Factor-based allocation has become increasingly popular in recent years. But how to implement it in practice still remains a puzzle for many newcomers. One concern often voiced by investors is avoiding excessive portfolio rotation.
One oft-heard criticism of explicit allocation to factors is that it inevitably leads to high, or even excessive, portfolio turnover. Indeed, while following a cap-weighted market index can essentially be seen as a ‘buy-and-hold’ approach, with limited portfolio activity, explicit allocation to factors necessarily leads to more dynamic trading.
In cap-weighted indices, stock weights fluctuate naturally with the prices of constituent securities, and changes in the portfolio composition are only triggered by large changes in free-float capitalizations or corporate actions such as mergers, splits or new listings or delistings.
On the contrary, factor-based investment strategies generate turnover from the periodic rebalancing required to maintain optimal exposure to the targeted premiums, for example value, momentum, low volatility or quality. This necessary turnover has led many academics and investors to question whether factor-based solutions are really worthwhile, given the higher trading costs associated with these strategies.
For example, a recent study(1) by Research Affiliates warned about the significant slippage between the factor returns realized by mutual fund managers and the theoretical factor returns that would have been achieved by virtual portfolios, over the 1991–2016 period. The authors attributed this gap to a number of costs related to implementation, including trading costs.
In a 2016 white paper(2), Joop Huij and Georgi Kyosev, of Robeco’s Quant research team, warned specifically about the high rebalancing costs implied by the replication of some common smart beta indices. Analyzing the impact of composition changes for two popular indices, they found that these costs are actually higher than they might appear, as the rebalancing process also leads to lower index returns. This is because strategies that follow publicly available indices, for which changes are announced in advance, tend to buy stocks that have just had a price run-up, and sell stocks that have just suffered a price decrease.
More generally, an FTSE Russell survey carried out in 2016 suggested that avoiding excessive portfolio turnover ranked fourth among investor concerns, when considering factor-oriented allocation.
But while the risk of excessive turnover should not be overlooked, it should not be exaggerated, either. In fact, it is possible to considerably reduce turnover without hampering performance too much. Robeco’s in-house research shows that when investors start keeping securities with less attractive factor qualities in their portfolios for longer, trading costs tend to decrease faster than the gross return. As a result, the net return/risk ratio tends to increase when turnover starts to decline.
‘Turnover can be reduced without lowering gross returns too much, but only up to a certain point’
This finding does not mean that portfolio changes should be minimized. Turnover can be reduced without lowering gross returns too much, but only up to a certain point. And gross returns also tend to drop rapidly once we allow unattractive securities to remain in the portfolio for too long or rebalance too infrequently. Investors must therefore find the optimal trade-off between factor exposure and rebalancing costs, in order maximize after-cost performance.
There are many ways to reduce and control portfolio turnover, and that can be applied to all kinds of factor-based strategies. The most obvious one is setting and adjusting fixed rebalancing intervals, in order to reassess factor exposures more or less frequently. Another option is allowing a portfolio to deviate more or less from its ideal composition, if only factor exposures were taken into account and implementation costs were neglected. The greater the deviation tolerance, the lower the turnover will tend to be.
In addition to these general techniques, which are widely used by investment managers and index providers, there are also more strategy-specific ways to reduce turnover. Empirical studies carried out on the short-term reversal phenomenon, which has been extensively documented in the academic literature, provide a good illustration of this.
Short-term reversal strategies exploit the fact that stocks that experience huge gains or losses during one month tend to reverse that trend the following month. However, many investors remain skeptical about this kind of approach because they involve huge turnover, as signals typically change completely every month.
But a 2011 paper(3) by Wilma de Groot, Joop Huij and Weili Zhou, of Robeco’s Quant Equity research team, showed that the high transaction costs incurred in many these investment strategies implemented in the US stock market could largely be attributed to excessive trading in small caps. Trading costs could therefore be significantly reduced by limiting the stock universe to large caps. Similarly, comparable ways to reduce turnover can often be found for different kinds of quantitative strategies.
All of Robeco’s quantitative strategies use portfolio-construction processes designed to keep trading low and trading costs under control, using a securities-ranking approach. This kind of method is less sensitive to changing market inputs. Moreover, for credit markets, which lack the immediacy seen in equity markets and where keeping transaction costs under control proves more challenging(4), we have developed a specific investment process, in which liquidity management is actually embedded in the portfolio construction process itself. This enables us to send only those orders which have a high probability of being executed.
The contents of this document have not been reviewed by the Securities and Futures Commission ("SFC") in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. This document has been distributed by Robeco Hong Kong Limited (‘Robeco’). Robeco is regulated by the SFC in Hong Kong.
This document has been prepared on a confidential basis solely for the recipient and is for information purposes only. Any reproduction or distribution of this documentation, in whole or in part, or the disclosure of its contents, without the prior written consent of Robeco, is prohibited. By accepting this documentation, the recipient agrees to the foregoing
This document is intended to provide the reader with information on Robeco’s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. Investment decisions should only be based on the relevant prospectus and on thorough financial, fiscal and legal advice. Please refer to the relevant offering documents for details including the risk factors before making any investment decisions.
The contents of this document are based upon sources of information believed to be reliable. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.
Investment Involves risks. Historical returns are provided for illustrative purposes only and do not necessarily reflect Robeco’s expectations for the future. The value of your investments may fluctuate. Past performance is no indication of current or future performance.
Please read this information carefully.
This website is prepared and issued by Robeco Hong Kong Limited ("Robeco"), which is a corporation licensed by the Securities and Futures Commission in Hong Kong to engage in Type 1 (dealing in securities); Type 4 (advising in securities) and Type 9 (asset management) regulated activities. The Company does not hold client assets and is subject to the licensing condition that it shall seek the SFC’s prior approval before extending services at retail level. This website has not been reviewed by the Securities and Futures Commission or any regulatory authority in Hong Kong.
2. Important risk disclosures
2. Important risk disclosures Robeco Capital Growth Funds (“the Funds”) are distinguished by their respective specific investment policies or any other specific features. Please read carefully for the risks of the Funds:
3. Local legal and sales restrictions
The information contained in the Website is being provided for information purposes.
Neither information nor any opinion expressed on the Website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. The information contained in the Website does not constitute investment advice or a recommendation and was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. An investment in a Robeco product should only be made after reading the related legal documents such as management regulations, prospectuses, most recent annual and semi-annual reports, which can be all be obtained free of charge at www.robeco.com/hk/en and at the Robeco Hong Kong office.
4. Use of the Website
The information is based on certain assumptions, information and conditions applicable at a certain time and may be subject to change at any time without notice. Robeco aims to provide accurate, complete and up-to-date information, obtained from sources of information believed to be reliable. Persons accessing the Website are responsible for their choice and use of the information.
5. Investment performance
No assurance can be given that the investment objective of any investment products will be achieved. No representation or promise as to the performance of any investment products or the return on an investment is made. The value of your investments may fluctuate. The value of the assets of Robeco investment products may also fluctuate as a result of the investment policy and/or the developments on the financial markets. Results obtained in the past are no guarantee for the future. Past performance, projection, or forecast included in this Website should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. Fund performance figures are based on the month-end trading prices and are calculated on a total return basis with dividends reinvested. Return figures versus the benchmark show the investment management result before management and/or performance fees; the fund returns are with dividends reinvested and based on net asset values with prices and exchange rates of the valuation moment of the benchmark.
Investments involve risks. Past performance is not a guide to future performance. Potential investors should read the terms and conditions contained in the relevant offering documents and in particular the investment policies and the risk factors before any investment decision is made. Investors should ensure they fully understand the risks associated with the fund and should also consider their own investment objective and risk tolerance level. Investors are reminded that the value and income (if any) from shares of the fund may be volatile and could change substantially within a short period of time, and investors may not get back the amount they have invested in the fund. If in doubt, please seek independent financial and professional advice.
6. Third party websites
This website includes material from third parties or links to websites maintained by third parties some of which is supplied by companies that are not affiliated to Robeco. Following links to any other off-site pages or websites of third parties shall be at the own risk of the person following such link. Robeco has not reviewed any of the websites linked to or referred to by the Website and does not endorse or accept any responsibility for their content nor the products, services or other items offered through them. Robeco shall have no liability for any losses or damages arising from the use of or reliance on the information contained on websites of third parties, including, without limitation, any loss of profit or any other direct or indirect damage. Third party off-site pages or websites are provided for informational purposes only.
7. Limitation of liability
Robeco as well as (possible) other suppliers of information to the Website accept no responsibility for the contents of the Website or the information or recommendations contained herein, which moreover may be changed without notice.
Robeco assumes no responsibility for ensuring, and makes no warranty, that the functioning of the Website will be uninterrupted or error-free. Robeco assumes no responsibility for the consequences of e-mail messages regarding a Robeco (transaction) service, which either cannot be received or sent, are damaged, received or sent incorrectly, or not received or sent on time.
Neither will Robeco be liable for any loss or damage that may result from access to and use of the Website.
8. Intellectual property
All copyrights, patents, intellectual and other property, and licenses regarding the information on the Website are held and obtained by Robeco. These rights will not be passed to persons accessing this information.
10. Applicable law
The Website shall be governed by and construed in accordance with the laws of Hong Kong. All disputes arising out of or in connection with the Website shall be submitted to the exclusive jurisdiction of the courts of Hong Kong.