Portfolio considerations
Reducing the static in factor funds
February 06, 2025
Remember when tuning in to your favorite song on the radio was an exercise in frustration, as static interfered with the musical moment? Investors looking to capture the returns from certain investing factors, such as value or momentum, may encounter a different kind of static. Their portfolios might experience significant tracking error or style drift, or fail to consistently capture the desired factor—all of which can diminish returns. That’s why it’s important for investors and advisors to dig into the details when they consider investing in a factor fund.
Maximizing factor impact through active rebalancing
Just as digital radio enables listeners to lock in a signal and achieve a clear sound, active management of factor funds can help deliver greater average exposure to the target factor, reduce unintended style drift and volatility, and increase the chance of higher returns.
Many factor funds are managed statically, getting rebalanced following a set schedule, often twice a year. At Vanguard, portfolio managers take a more active approach, monitoring the factor funds daily and making trading decisions accordingly. This flexibility can improve investor outcomes.
To measure how actively managing factor funds affects their performance, we first build value and momentum benchmarks based on the same rules that Vanguard’s Quantitative Equity Group applies to our factor funds.1 These value and momentum benchmarks are refreshed daily, ensuring that stock weights are updated with the latest factor data, and are designed to reflect a pure factor implementation. We then create two types of investment portfolios from the universe of stocks in the Russell 3000 Index to track these daily-updating factor benchmarks.
The first portfolio mechanically rebalances semiannually to fully replicate the established benchmark subject to trading constraints, such as a 10% average daily trading volume limit and a required minimum holding size of two basis points.2 (A basis point is one-hundredth of a percentage point.) The static portfolio is akin to a less dynamic, rule-based, and non-market-weighted active factor portfolio.
The second portfolio takes a more active approach. In addition to the trading constraints, active portfolio managers rebalance these portfolios when the tracking error relative to our benchmark portfolio surpasses 2% or when factor capture falls below an established threshold.3,4 Upon rebalancing, value capture is forced to 98% and momentum capture to 95%, while minimizing the tracking errors relative to the daily-updated factor benchmarks.
The vertical axis on the chart below describes the level of factor exposure in each portfolio relative to their daily-updated benchmarks. We can see that the actively managed implementations deliver a higher proportion of the factor signal and with more consistency than their static counterparts. This is especially true for the momentum portfolio, which generates a 20% greater exposure, on average, because the momentum signal decays quickly.
Dynamic rebalancing helps funds capture more of the factor signal
Note: To analyze more realistic trading scenarios, we calculated daily factor scores using quarterly fundamental data (where applicable) and daily market prices.
Reducing tracking error with more frequent rebalancing
The actively managed value and momentum portfolios have significantly tighter tracking error relative to the benchmark portfolios. This reduces the risk of deviating from the signal benchmark, as the next chart shows.
More frequent rebalancing also helps reduce risk during periods of heightened volatility. Although this research did not take into account the tax effect of rebalancing, we assumed that ETFs’ ability to use in-kind transactions to rebalance could help minimize tax consequences.
Average daily level and change in tracking error relative to target benchmarks
Source: Vanguard calculations, using Bloomberg data.
More precise factor exposure can enhance cost-adjusted returns
Even after estimated trading costs, the active portfolio generated higher returns for the period from January 4, 2000, through November 30, 2022, as the next chart shows. Slippage accounts for the cost of deviations from the benchmark portfolios caused by rebalancing strategies and restrictions, such as the maximum amount of a stock a single fund can hold.
How after-cost returns compare for active and static portfolios
Sources: Vanguard calculations, using Compustat and IBES data for the period from January 4, 2000, through November 30, 2022. Past performance is no guarantee of future returns.
Reaching factor investing’s full potential
Factor funds can be a savvy option for investors who believe in specific investment styles, such as value or momentum, and who are willing to tolerate periods of volatility and invest for the long run. Factor investing that actively rebalances to maintain a high percentage of the factor signal can reduce tracking error to the benchmark portfolios and increase the chances of harvesting the returns that factors can provide. It’s essential, however, that investors and advisors dig into the details of factor-fund management and match them to individual investors’ objectives.
1 The value strategy uses book-to-market, earnings-to-price, and cash-flow-to-price ratios as individual signals. The momentum strategy uses 12-month momentum, six-month momentum, and 52-week risk-adjusted momentum signals. To calculate value or momentum exposures, we sort stocks into three size groups: large, midsize, and small. The large group contains the 200 largest stocks, the midsize group 800 mid-capitalization stocks, and the small group 2,000 small stocks. Then we calculate a set of standardized signals as the percentiles of individual raw signals within each group. Lastly, the standardized signals are averaged, and the composite signal for each stock is represented by the percentile of this average within each group.
2 Additional constraints are that each rebalancing begins with a 10% turnover for value and 15% for momentum. Furthermore, stock ownership must not exceed the 3-day average daily volume and must not exceed 5% of the stock's total ownership.
3 Factor capture is defined as the ratio of our live portfolio’s aggregate exposure to the target factor relative to the benchmark portfolio’s aggregate exposure.
4 We establish a threshold of 95% for value and 90% for momentum. Momentum’s threshold is lower than value’s because of the faster decay of the underlying factor signal.
Related items:
- Q’s for quants: A chat with our quant equity managers (article, issued December 2024)
- A map to building factor-based portfolios (article, issued November 2023)
- Not all factors are created equal: Factors’ role in asset allocation (Research paper, issued November 2023)
Notes:
For more information about Vanguard funds and Vanguard ETFs, visit vanguard.com/fundprospectus or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.
Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
The Factor Funds are subject to investment style risk, which is the chance that returns from the types of stocks in which a Factor Fund invests will trail returns from U.S. stock markets. The Factor Funds are also subject to manager risk, which is the chance that poor security selection will cause a Factor Fund to underperform its relevant benchmark or other funds with a similar investment objective, and sector risk, which is the chance that significant problems will affect a particular sector in which a Factor Fund invests, or that returns from that sector will trail returns from the overall stock market.
