Factor investing challenges: factor timing

• 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.

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.

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.

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

² ‘My Factor Philippic’, Cliff Asness, 2016.