Factor investing can deliver huge advantages to clients and thankfully there are many strategies to choose from. Combining factors, say, enables portfolios to harvest different risk premiums whilst enjoying diversification benefits. Meanwhile a more integrated multi-factor approach avoids some of the pitfalls of simply implementing factors top-down. So-called dynamic factor investing is different again. It allocates between factors in response to changing market environments. Such an adaptive approach is the focus of this introductory paper.
It may not be for everyone. For example single factors can be more appropriate for clients already invested with active managers or those with strong market views. Likewise a static yet diversified exposure to various factors may be the way to go – multi-factor strategies help boost risk adjusted returns via diversification.
For investors concerned with achieving stable returns across volatile conditions – or fearful of a structural break in markets – we believe that a more adaptive approach could be the answer.
Dynamic factor investing does not rely on forecasting the future. It allocates to factors with the most predictive power, along with those with the most statistically significant persistence in terms of returns. Historical data shows that years of outperformance in a single factor can be followed (or proceeded) by a long stretch of underperformance. That is why it can help to move between them – ideally beforehand but even after markets have moved to a new regime.
Structural breaks not only affect the returns of broadly defined factors such as value, but also the optimal definitions or representations of those factors. For example, while price to earnings or price to book may work well in a normal market environment, cash-flow related measures often deliver superior performance in times of market turmoil.
Factors are then re-selected or re-weighted each month to reflect changing conditions. The key to dynamic factor investing is to draw from a broad range of factors within a cluster in order to adapt to changing markets. As mentioned, in some environments one ratio may be offering a better signal within a valuation cluster, while in another month it may be a different metric.
By reacting to signals in this way and combining this with a given stock’s exposure to these signals, it is possible to give holdings an attractiveness score. This becomes the basis of a robust and dynamic portfolio construction process.
The beauty of factors is there is now a suite of strategies to choose from. Where appropriate, investors should investigate dynamic factors as a compliment to their existing strategies.
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