One of the most frequent questions I get from readers is how to combine equity factor tilts into a portfolio that produces long-run outperformance. Long-time readers know that I frequently author on the long-run structural alpha available in factor tilts covered in my "7 Ways to Beat the Market". Size, Value, Low Volatility, Dividend Growth, Equal-Weighting, Momentum, and Quality have all been shown to deliver higher risk-adjusted returns than the broad market. I have offered readers Qualitative and Quantitative approaches to building their own factor tilt portfolios, but have not demonstrated a dynamic way to rebalance between these factor tilt strategies to further enhance portfolio returns.
Recent research from Volker Flogel of Quoniam Asset Management and Christian Schlag and Claudia Zunft of Goethe University in Germany illustrates a novel timing strategy for constructing a portfolio of equity factor tilts. In their paper entitled Momentum-Managed Equity Factors, the trio developed a simple timing strategy that invests in factors based on previous month's excess return relative to past levels. They show that time series momentum predicts excess returns of key equity factors.
The authors documented their findings from the construction of factor portfolios formed on the broad market, size, value, momentum, investment, profitability, and volatility factors. They then showed that factor management through the employment of short-term momentum improved absolute and risk-adjusted returns to a degree that was significant and strongly covered transaction costs. Their sample study period covered more than five decades in the United States, and multiple business cycles in international markets.
Readers know that the returns to factor portfolios are time-varying. Low Volatility (SPLV), (USMV) has been dominating of late as interest rates have rallied and multiples of defensive stocks have expanded. Conversely, Value (RPV) and Size (IJR) have been underperforming recently, and tend to generate their market-beating returns early in an economic cycle. The research discussed herein examines ways to hold more (less) of a factor when its expected return is high (low).
The key metric in this study is a "timing signal" which contains information on the expected next-month excess return for a given equity factor. To create this signal, the authors calculated z-scores of the last-month excess return for each factor and then computed the associated probability value assuming a standard normal distribution. The resulting timing signal approached 1 when the last-month excess return of the factor was very high relative to past levels and approached 0 when it was very low. Effectively, short-term momentum was used to create a load for a given factor that scaled its excess returns up and down.
This process of scaling exposure to a given factor based on momentum increased risk-adjusted returns for 6 of the 7 factors (excluding Investment), and was particularly robust for Size and Volatility. Higher absolute returns boosted risk-adjusted returns and Sharpe ratios. This approach also reduced 12-month drawdowns. While turnover is necessarily higher for a momentum-influenced strategy, the authors documented that excess returns were still prevalent even after accounting for what seemed like above-market transaction costs. Higher returns and lower risk is the "alpha" we are collectively seeking.
The equity factors depicted in this paper are long-short portfolios. I hope to build on this work by examining the effect of momentum in the factor tilts in my ongoing series on the topic. This paper gives me guarded optimism that there might be something to uncover through examining short-term momentum of those factor tilts, and I hope to illustrate a demonstrable pattern that is investible through low cost market instruments for Seeking Alpha readers.
Understanding the impact of short-term momentum on factor tilt portfolios can aid in asset allocation decisions, and inform the quality of the design and implementation of multi-factor funds that are becoming increasingly more popular. I hope this article serves as a good introduction to this new research for Seeking Alpha readers, and I hope to examine ways to potentially deploy these findings in a manner that can add value.
My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term, risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance and investment horizon.
Disclosure: I am/we are long RPV,SPLV,USMV,IJR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.