Written by: Deepika Sharma, Managing Director of Investment Research, Astor Investment Management
For decades, investors have been interested in factors—attributes such as value, momentum or market capitalization. But as investors have also experienced, as certain styles or themes go out of favor, factors typically go through periods (and potentially extended periods) of underperformance.
Now, investors are looking more closely at factor rotation, shifting from, say, growth to value, or overweighting low volatility stocks rather than value stocks.
But how? In the short term, the best way to avoid underperformance in any particular factor is with diversification rather than tactical timing. For the medium and long term, however, there is evidence that using macroeconomic and other risk-based approaches may be effective for factor rotation.
Why do Investors Want Factor Rotation?
The potential for factor rotation appears to come at a good time as index-based factor investing in U.S. equity markets has proliferated. But there appears to be a widespread temptation among investors to time exposure based on what seems to be currently in favor. This attempt to choose factors is not without reason, as past performance shows that even established factors can, occasionally, underperform for long periods. The classic example is value, as illustrated in Exhibit 1, which has historically done better than growth. But there are marked periods when growth beat value by as much as 11.4% in one year.
Not only can factors underperform based on market conditions, different factors also offer varied risk-return profiles. As shown in Exhibit 2, the five single factors most commonly used by investors—value, momentum, size or market cap, quality, and minimum volatility— all have very different average return and volatility compared to the broad market index. In addition, one factor can be relatively more attractive for a short time period. For example, during the market contraction that lasted from December 2007 to June 2009, the Russell 1000 Low Volatility factor outperformed the value factor by 12%. In the last two years, however, the two indices have tracked much more closely (Exhibit 3).
Source: Bloomberg, Astor Calculations (June 2001-March 2017) Value is represented by Russell 1000 Value Factor Index, Minimum Volatility is represented by the Russell 1000 Low Volatility Factor Index, Quality is represented by the Russell 1000 Quality Factor Index, Size is represented by the Russell 1000 Size Factor Index, Momentum is represented by the Russell 1000 Momentum Factor Index.
Can Factors Be Timed?
In hindsight, of course, it seems obvious to discern when to overweight a particular factor. But engaging in factor rotation in real time can be challenging, as research studies  have shown. At the same time, diversification appears to be sub-optimal for medium and long term, because strategies such as momentum can potentially suffer massive drawdowns in a short period of time and erase months or years of returns. This is because momentum returns are negatively skewed; when negative returns are clustered, losses can become extreme, such as during the three-month period of March-May 2009 when a long-short momentum strategy lost as much as 156% .
Macroeconomic or Risk-Based Approach
We believe there is evidence that a regime-based medium- to long-term model is better suited for overweighting specific factors; for instance, a well-known early work by Lucas (2002)  finds that business cycle-oriented style rotation delivers better performance than pure statistical methods.
At Astor, we use our proprietary macroeconomic indicator, the Astor Economic Index®, combined with risk metrics, to determine when market conditions or business cycle appear to favor a particular factor.
Exhibit 4: Average Monthly Returns of Russell 1000 Momentum Factor Index in various stages of economic growth cycle as measured by the Astor Economic Index® and stock market volatility (measured by VIX)
As Exhibit 4 illustrates, the momentum factor is best avoided when the economy is weak and stock market volatility is high. In fact, during times of market contractions, low volatility stocks have historically provided a buffer, potentially leading to outperformance in bear markets while tending to lag during bull markets as shown in an earlier example.
In conclusion, there are valid grounds for pursuing factor rotation, because performance among factors typically varies based on market conditions. But how to accomplish that goal has eluded investors. In the short-term, research suggests that diversification across multiple factors is the best way to guard against unfavorable performance in a specific factor.
For the medium and long term, however, research suggests that other approaches can be effective for factor rotation. Using the business cycle or a risk-based approach appears promising to determine the macroeconomic conditions that would likely be better suited for one factor versus another.
Learn how to effectively allocate your client’s portfolio here.
 Asness, Clifford S. and Chandra, Swati and Ilmanen, Antti and Israel, Ronen, “Contrarian Factor Timing is Deceptively Difficult”, (March 7, 2017). Journal of Portfolio Management, Forthcoming.
 Kent Daniel, Tobias J. Moskowitz, “Momentum Crashes”, Journal of Financial Economics (November 2016)
 André Lucas, Ronald van Dijk, Teun Kloek, “Stock Selection, Style Rotation, and Risk”, Journal of Empirical Finance, Volume 9, Issue 1, January 2002
All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.”
The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. The Astor Economic Index® is a tool created and used by Astor. All conclusions are those of Astor and are subject to change.
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