Factor Rotation: Unlocking returns through market cycles

Key takeaways

1. Factor rotation seeks to capitalize on cyclical leadership trends by dynamically adjusting exposures as market conditions evolve. 
2. Combining economic, valuation, sentiment, and factor-specific signals provides a holistic view of factor opportunities, helping to maximize return potential over time.
3. The iShares U.S. Equity Factor Rotation Active ETF (DYNF) seeks to outperform the broad U.S. equity market by dynamically rotating across historically rewarded style factors.

Harnessing cyclicality with dynamic stock selection

A significant share of recent market returns has been driven by a small group of mega-cap stocks, creating a challenging environment for many investors. At the same time, evolving interest rate expectations, tariff uncertainty, and geopolitical risks have contributed to elevated market volatility. Against this backdrop, dynamic factor rotation strategies may offer a differentiated approach by adjusting exposures as market leadership changes.

Strategic factor portfolios that allocate across styles like value, momentum, and quality have historically delivered excess risk-adjusted returns relative to broad market- indexes, benefiting investors with the patience to diversify risks and capture returns.¹ However, this does not guarantee future results, and these returns have not been evenly distributed through time. As economic conditions, investor sentiment, and valuations evolve, leadership rotates across factors, creating periods of both outperformance and underperformance for individual styles.

This cyclical behavior presents a key challenge: maintaining diversified factor exposure while adapting to changing market leadership. Factor rotation strategies, like the iShares U.S. Equity Factor Rotation Active ETF (DYNF), seek to address this challenge by dynamically adjusting factor exposures as conditions change, helping investors capture opportunities across varying market environments.

Factor performance across market cycles

Factor rotation is grounded in the observation that different investment styles tend to perform best at different points in the economic cycle. For example, quality and low volatility factors have historically shown resilience during periods of slowing growth or heightened uncertainty, while value and momentum factors have often benefited during recoveries and expansions.²

Figure 1: Factor behavior across economic regimes

Rather than maintaining static allocations, factor rotation strategies seek to identify these shifts in market leadership and dynamically adjust exposures accordingly. By analyzing a broad set of economic indicators, we identify the current phase of the economic cycle and assess which factors have historically demonstrated the strongest performance in similar market conditions.

By aligning portfolio positioning with prevailing economic and market conditions, investors may be better positioned to capture opportunities as leadership rotates across factors over time.

How our factor rotation process works

While precisely timing factors is challenging, we believe a systematic approach to factor timing can add value. Our process aims to evaluate factors both relative to their own history and relative to one another.

Over the long term, the portfolio seeks to maintain diversified exposure across multiple equity factors. In the short term, however, the strategy dynamically adjusts exposures based on changing market conditions, increasing allocations and tilts into factors with tailwinds and away from factors with headwinds.

Figure 2: Factor rotation in practice

Figure 2 illustrates how our factor exposures evolved across different market environments:

• 2023: AI-driven market concentration emerges
  As inflation moderated and the Federal Reserve slowed the pace of rate hikes, market sentiment improved. The strategy's overweight positions in growth, quality, and mega-cap stocks benefited from the narrow rally led by the "Magnificent Seven."³
• 2024: Growth leadership continues
  AI-driven optimism extended technology leadership throughout the market. Continued exposure to growth, quality, and mega-cap stocks supported performance as investor enthusiasm around artificial intelligence remained strong.
• 2025: Navigating volatility through dynamic factor exposure
  While AI adoption continued to support mega-cap technology companies, inflation concerns and tariff uncertainty increased market volatility. The strategy maintained a risk-on stance with broad factor exposure while remaining underweight small-cap stocks.

Figure 3: Zooming in on 2026 factor positioning

The factor tilts shown in Figure 3 were driven by a systematic process designed to adapt to evolving market conditions. As leadership shifted from AI-driven growth stocks to a more volatile and uncertain environment, the model continuously reassessed which factors were most likely to be rewarded. This adaptive approach is powered by a combination of factor timing signals that work together to inform portfolio positioning.

Better together: A holistic model

The fund’s changing factor exposures reflect the output of our broader factor timing framework. Rather than relying on a single market signal, the fund integrates multiple insights to identify potential opportunities and risks across different market environments.

Our dynamic framework incorporates the following complementary factor timing indicators:

• Economic regime – Assessment of the current economic and market regime, and whether the factor has historically performed well in the identified environment.
• Valuation – Assessment of whether the factor is cheap or expensive relative to its own history and compared with other factors.
• Sentiment – Evaluation of current market sentiment toward the factor, including whether sentiment is broadly positive or negative.
• Factor-specific insights – Assessment of factor-specific considerations, including whether future growth is already priced in and whether there is an elevated risk of a momentum reversal.

By combining these perspectives, the strategy seeks to create a more robust and adaptive stock selection process rather than relying on any single signal alone.

What factor rotation means for client portfolios

In today’s evolving market environment, investors are rethinking how they allocate across equity factors. DYNF seeks to simplify tactical factor implementation by combining factor timing and stock selection within a single actively managed ETF. Rather than rotating among individual factor ETFs, investors can access a dynamic strategy that adjusts as market conditions change and can serve as a core or complementary exposure within the portfolio.

The fund invests across U.S. large- and mid-cap stocks, seeking exposure to the factors our systematic process identifies as best positioned for the current environment. As market leadership evolves, the portfolio evolves with it — providing investors with a streamlined, actively managed approach to factor investing designed to adapt across market cycles.