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.
This material is for distribution to Professional Clients (as defined by the FCA or MiFID Rules) and Qualified Investors only and should not be relied upon by any other persons. Issued by BlackRock Investment Management (UK) Limited, authorised and regulated by the Financial Conduct Authority. Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Tel: 020 7743 3000. Registered in England No. 2020394. For your protection telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited. Past performance is not a guide to current or future performance. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested. Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase. Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially. Levels and basis of taxation may change from time to time. Any research in this document has been procured and may have been acted on by BlackRock for its own purpose. The results of such research are being made available only incidentally. The views expressed do not constitute investment or any other advice and are subject to change. They do not necessarily reflect the views of any company in the BlackRock Group or any part thereof and no assurances are made as to their accuracy. This document is for information purposes only and does not constitute an offer or invitation to anyone to invest in any BlackRock funds and has not been prepared in connection with any such offer. © 2017 BlackRock, Inc. All Rights reserved. BLACKROCK, BLACKROCK SOLUTIONS, iSHARES, BUILD ON BLACKROCK, SO WHAT DO I DO WITH MY MONEY and the stylized i logo are registered and unregistered trademarks of BlackRock, Inc. or its subsidiaries in the United States and elsewhere. All other trademarks are those of their respective owners.
©2017 funds europe
