Factor Investing - a Time to Tilt

In my many conversations with investors and industry peers about factor investing, one topic seems to always come up: factor investing timing. I’ve had recent discussions on this topic with a central bank whose managers need to think about preserving capital and with a more nimble RIA team which explicitly wants to use timing to pursue
incremental returns.

Factors, which are broad, historically persistent drivers of return, are inherently cyclical: Because each factor is driven by different phenomena, they tend to outperform at different times. How can investors aim to take advantage of this cyclicality of factor premiums in funds?

Our view: Market timing is difficult to accomplish, and with factors, it is no different. Rushing in and out of a factor strategy can cause harm to long-term returns and erode a portfolio’s diversification. That said, factors do demonstrate some cyclicality, which offers opportunity to improve the prospects of a diversified factor portfolio.

We believe there is a better way. When using factors in your investing strategy, rather than going in and out of factors, consider starting with a portfolio that is well diversified across key factors. Most investors can rebalance to those strategic factor weights.

Some investors might want to go further, and implement modest tilts around that strategic factor allocation. Factor tilting, rather than short-term in-and-out timing, can balance opportunities to seek improved returns while maintaining the potential long-term benefits of a well-diversified factor portfolio.

What signals might an investor use to tilt toward or away from factors over time?

How we tilt factor investments

Our research indicates that it’s possible to tilt to various factors to add incremental return to a multifactor portfolio by over- and underweighting select factors relative to others, while maintaining long-term exposure to all factors.

Here’s how. Let’s consider five equity style factors: value, size, momentum, quality and minimum volatility. For each factor, we consider four indicators to determine whether to tilt towards or away from the factor.

We start by assessing macroeconomic conditions to determine if the factor could be helped or hindered by the current environment. For example, during the expansion phase of the business cycle, when growth is accelerating, the momentum factor has tended to perform well.

Next, we review valuation to see whether the factor is expensive or cheap relative to its own history.

Relative strength measures whether the factor has had strong recent performance.