A Systematic Framework to Factor Tilting

Key takeaways

  • Factors are long run drivers of portfolio risk and returns. Having strategic allocations to factors may increase a portfolio’s expected return.
  • As factor performance is cyclical, investors may be able to drive additional alpha in portfolios by tilting towards factors in a systematic way.
  • Tilting decisions to any factor can be driven by the current economic regime, valuations, and sentiment.

Some of you may be familiar with an analogy that I’ve used during presentations and in my book, Asset Management – Factors are to assets what nutrients are to food. Just as individuals have different nutritional needs, investors have different optimal exposures to different risk factors.1

Long-term strategic overweights to certain style factors – value, quality, momentum, small size, and minimum volatility – can help investors increase their portfolio’s expected returns, reduce risk, or improve diversification. But sometimes things happen to us as individuals causing us to have varying nutritional needs. If you’re sick, some delicious chicken soup might help! A runner getting ready for a triathlon may decide to eat more carbohydrates to power her body for the run. If you’re anemic, then eating a diet with iron-rich foods like red meat, beans, and spinach would be appropriate. In a similar vein, factor investors may decide to overweight or underweight certain factors in their portfolio based on 1) what economic regime we’re in, 2) current valuations, and 3) sentiment.