Does active stock factor exposure management boost overall portfolio performance? In their November 2018 paper entitled “Optimal Timing and Tilting of Equity Factors”, Hubert Dichtl, Wolfgang Drobetz, Harald Lohre, Carsten Rother and Patrick Vosskamp explore benefits for global stock portfolios of two types of active factor allocation:
- Factor timing – exploit factor premium time series predictability based on economic indicators and factor-specific technical indicators.
- Factor tilting – exploit cross-sectional (relative) attractiveness of factor premiums.
They consider 20 factors spanning value, momentum, quality and size. For each factor each month, they reform a hedge portfolio that is long (short) the equal-weighted fifth, or quintile, of stocks with the highest (lowest) expected returns for that factor. For implementation of factor timing, they consider: 14 economic indicators standardized by subtracting respective past averages and dividing by standard deviations; and, 16 technical indicators related to time series momentum, moving averages and volatilities. They suppress redundancy and noise in these indicators via principal component analysis separately for economic and technical groups, focusing on the first principal component of each group. They translate any predictive power embedded in principal components into optimal factor portfolio weights using augmented mean-variance optimization. For implementation of factor tilting, they overweight (underweight) factors that are relatively attractive (unattractive) based on valuations of factor top and bottom quintile stocks, top-bottom quintile factor variable spreads, prior-month factor returns (momentum) and volatilities of past monthly factor returns. Their benchmark portfolio is the equal-weighted combination of all factor hedge portfolios. For all portfolios, they assume: monthly portfolio reformation costs of 0.75% (1.15%) of turnover value for the long (short) side; and, annual 0.96% cost for an equity swap to ensure a balanced portfolio of factor portfolios. For monthly factor timing and tilting portfolios only, they assume an additional cost of 0.20% of associated turnover. Using monthly data for a broad sample of global stocks from major equity indexes and for specified economic indicators during January 1997 through December 2016 (4,500 stocks at the beginning and 5,000 stocks at the end), they find that:
- The available out-of-sample test period is January 2003 through December 2016.
- The benchmark portfolio generates average annualized net return 2.21%, annualized volatility 2.72%, annualized net Sharpe ratio 0.81 and maximum drawdown -4.59%. Annualized two-way turnover is 26%.
- The factor timing portfolio generates average annualized net return 2.30%, annualized volatility 2.84%, annualized net Sharpe ratio 0.81 and maximum drawdown -6.49%. Annualized two-way turnover is 554%.
- Various factor tilting alternatives generate average annualized net returns in the range 1.12% to 2.55%, annualized volatilities in the range 2.61% to 3.20%, annualized net Sharpe ratios in the range 0.41 to 0.83 and maximum drawdowns in the range -4.13 to -8.33%. Annualized two-way turnovers range from 69% to 409%.
- Taming the active factor allocations based on transaction penalties or suppression of mean-variance optimization allocation swings sometimes offers modest, but not compelling, performance improvements.
In summary, evidence indicates that, despite elaborate strategies, active factor timing and tilting offer little or no improvements over equal factor weighting on a net basis, with turnover frictions generally offsetting any gross improvements.
Cautions regarding findings include:
- The sample period is short in terms of some indicator lookback intervals and, especially, in terms of variety of market conditions.
- Testing many factor timing and tilting alternatives and refinements on the same data introduces data snooping bias, such that the best-performing scenarios overstate expectations.
- The approaches described are beyond the reach of most investors, who would bear fees for delegating to a fund manager.
