For equity factor strategies, beware the wrinkles in timing

January 23, 2019

 
Doug Grim

Doug Grim
Senior Investment Strategist

Interest in using equity factor strategies to help clients meet their investment objectives is increasing, and advisors often ask if factor-timing strategies can enhance clients' returns—particularly given the cyclicality of factor returns. It's a tricky question to answer because measuring "success" creates a wrinkle—or challenge—for many.

Ironing out a prudent benchmarking mind-set

When considering which investment strategies to use to meet various objectives, advisors often contemplate what benchmark would be prudent for comparison. In this case, it provides a way of assessing performance relative to how advisors could otherwise strategically deploy their clients' hard-earned assets—without the use of timing. Some believe a low-cost, broad-market capitalization-weighted index fund makes sense as the benchmark for a factor-timing strategy.

For instance, advisors who consider equity factor funds for a timing strategy typically believe that those same factors will outperform a broad-market index fund over the long term without timing. Their objective is for the timing strategy to add to a return that could otherwise be generated by simply buying and holding a diversified group of factors. In this situation, more relevant choices for comparison should be considered to help the advisor determine the true value-add (risk and return) of the timing strategy. These options include:

  • Performance of an equally weighted mix of single-factor strategies.
  • Performance of a multifactor fund that combines factors using bottom-up (integrated) portfolio construction.

These represent practical ways an advisor could strategically tilt toward a set of equity factors in a low-cost, diversified way without judging which factor to overweight or underweight at different times. To make the benchmark comparison truly apples-to-apples, the advisor should consider the impact of all-in costs of each approach, including those when fund trades are made.1

Keep it wrinkle-resistant

Advisors who already use equity factor funds to achieve certain investment objectives remind their clients up front that strategically owning single-factor equity funds, as with other types of active strategies, will produce periodic ups and downs. Timing factors, some believe, is a way to make the roller-coaster ride less bumpy and more gratifying (profitable).

Absent a strong conviction about differences in future expected returns and correlations across factors, an equally weighted combination is a sensible, diversified standard for most advisors with excess-return objectives. For those determined to implement a timing approach, appropriate benchmarking is a necessary component of the due diligence required to measure long-term success—and keep the wrinkles in timing at bay.

1 For your convenience, here is a one-page checklist of sample questions to ask when evaluating the back-tested results of a timing strategy.

Note: Factor funds are subject to investment style risk, which is the chance that returns from the types of stocks in which the fund invests will trail returns from the stock market. Factor funds are subject to manager risk, which is the chance that poor security selection will cause the fund to underperform relevant benchmarks or other funds with a similar investment objective.

Doug Grim

Doug Grim, CFA, is a senior investment strategist in Vanguard Investment Strategy Group, where he leads the team that conducts research and provides thought leadership on factor-based portfolio construction and environmental, social, and governance (ESG) issues in investing. Before his current role, he was a senior investment consultant in Vanguard Institutional Advisory Services®. In that position, he provided asset allocation and portfolio construction recommendations, investment policy consulting, and capital markets research to institutional clients. He also served as team leader responsible for assisting other consultants with all asset allocation and asset/liability modeling studies conducted for clients.

Mr. Grim earned a B.S. from the University of North Carolina at Wilmington. He is a CFA® charterholder and a member of the CFA Institute and the CFA Society of Philadelphia.

CFA® is a registered trademark owned by CFA Institute.

 

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