Andrew's Angle

Factors at full tilt

Capital at risk. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed.

Andrew Angle

In my many conversations with investors and industry peers about factor investing, one topic seems to always come up: factor 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 investment advisory team who explicitly wants to use timing to generate incremental returns.

Factors, which are broad, persistent drivers of return, are inherently cyclical: because each factor is driven by different phenomena, they tend to outperform at different times.1 How can investors take advantage of this cyclicality of factor premiums?

1. Source: MSCI Research – The Foundations of Factor Investing

Our view: Market timing is difficult to accomplish and with factors, it is no different. Rushing in and out of a factor can be clumsy and cause harm to long-term returns, as well as the diversification of a portfolio. That said, factors do demonstrate some cyclicality, which offers opportunity to potentially to up weight and down weight these factors throughout the market cycle

We believe there is a better way to use factors in your investing strategy. Rather than rapidly going in and out of factors, start with a portfolio that maintains an allocation across key factors (size, quality, momentum, value and minimum volatility).

Some investors might go further, and implement modest tilts around that strategic factor allocation. Factor tilting, rather than short-term in-and-out timing, can balance the potential opportunity to improve portfolio returns without fundamentally disrupting the long-term benefits of a diversified portfolio.

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

How we tilt

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.2

2. Source: Blackrock

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 is helped or hindered by the current environment. For example, during the expansion phase of the business cycle, when growth is accelerating, the momentum factor tends 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.

Another signal, dispersion measures how much opportunity a factor has to outperform in the current environment—or how similarly or dissimilarly the universe of stocks demonstrates factor characteristics. More dispersion creates more opportunity.

While each of the four indicators is valuable on its own, we think it is more effective to combine these four insights into a composite indicator. This tells us whether to under-, over- or neutral-weight the factor relative to the other factors, while still maintaining diversified exposure to all the factors over time—i.e. tilting, not timing.

How much does tilting add?

We’ve written extensively about the potential return benefits of a well-diversified multifactor portfolio relative to a benchmark index.3 Our hypothetical multifactor portfolio maintains equal-weighted exposure to all style factors. Adding modest tilts can in turn increase relative returns. The degree of the tilt for each of the five style factors will vary according to the strength of the over- or underweight indicator, but it could be as much as 15 percentage points of variance from the weighting in an equal-weighted portfolio.4

3. Sources: MSCI as at 29th December 2017. Multifactor represented by the MSCI World Diversified Multiple-Factor Index and benchmark index represented by the MSCI World Index.

Factor tilting may also add diversification benefits for investors already holding multifactor portfolios. When comparing the addition of a factor-tilting portfolio or a traditional, actively managed mutual fund, returns from the tilting portfolio may have lower correlation with the multifactor portfolio than returns of active mutual funds.4

4. Source: Factor Timing with Cross-Sectional and Time-Series Predictors by Philip Hodges, Ked Hogan, Justin Peterson and Andrew Ang.

How to implement

Investors may choose to incorporate tilting views in several ways: by explicitly allocating to a factor-rotation strategy within the equity allocation, by layering tilting insights over existing investments or by letting tilting views influence manager selection and rebalancing. Furthermore, the availability of factor ETFs provides the tools for implementation, and offer investors full transparency of their holdings.

Andrew Ang
Head of Factor Investing Strategies
Andrew Ang, PhD, Managing Director, coordinates BlackRock’s efforts in factor investing.