In this article Andrew Ang, PhD, discusses the concept of factor tilting.
In my many conversations with investors and industry peers about factor investing, one topic always seems to come up: factor timing. I’ve had recent discussions on this topic with a central bank whose managers explicitly want 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.
How can investors take advantage of this cyclicality of factor premiums?
Our view: Market timing is difficult to accomplish, and with factors, it is no different. Rushing in and out of a factor 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. To effectively use factors in your investing strategy, start with a portfolio that is well diversified across key factors. Most investors can rebalance to those strategic factor weights.
Some investors might go further and implement modest tilts around that strategic factor allocation. Factor tilting can balance opportunities to improve returns without fundamentally disrupting the long-term benefits of a well-diversified factor portfolio.
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.
Here’s how. We consider four indicators to determine whether to tilt towards or away from the factor.
1. 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.
2. Valuations - to see whether the factor is expensive or cheap relative to its own history.
3. Relative strength – to measure whether the factor has had strong recent performance.
4. Dispersion - measures how much opportunity a factor has to outperform in the current environment. 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 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. The availability of a wide range of factor ETFs makes implementation straightforward and transparent.
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