“When it comes to factor investing, you have to strike while the iron’s hot, and the iron doesn’t get that hot very often,” said Khang, head of active and alternatives research in Vanguard Investment Strategy Group. “When a particular factor strategy is in action, there is a lot of dynamism in the underlying factor, and you want to make sure you are keeping pace. Otherwise, you will miss out on an opportunity that may not return for another decade.”

What changes so quickly about a factor, and when does it happen? This usually occurs when the market is shifting from a bear to bull market, or vice versa—periods with high, persistent volatility. In these periods, the composition of a factor—specifically, the degree to which certain companies continue to reflect the underlying theme of the factor—tends to change significantly faster than in normal times.

Jiannino, who serves as senior product director in Vanguard Portfolio Review Department, said the most recent three-year period, which included the COVID-19 pandemic, demonstrates how factor exposures can change during periods of market uncertainty. Securities’ individual exposures to certain factors, such as momentum, value, and quality, can shift dramatically over time, and portfolio managers need to stay on top of these changes and respond by rebalancing their portfolios.

“Factor portfolio managers must think about what their portfolios should look like ideally and then determine how much they are deviating from that ideal portfolio,” Jiannino said. “They then should weigh the costs and benefits of rebalancing.”

Vanguard set out to determine the optimal rebalancing mechanism for long-only factor funds. Our research in this area culminated in Waiting for the Next Factor Wave: Daily Rebalancing Around Market Cycle Transitions, a research paper published in 2021 in The Journal of Portfolio Management.¹

“Looking at the last 30 years of factor investing performance, factor funds that maintained a consistent factor exposure by rebalancing more frequently—on a daily basis, instead of monthly or biannually—achieved significantly higher factor premia, especially during bull-to-bear-to-bull market transitions, and effectively doubled the historically observed premia of many factors,” Khang said. “These findings indicate that to harvest factor premia to their maximum potential, portfolio managers must weigh the value of rebalancing to enhance the portfolio’s exposure to the targeted factors against the costs of doing so. Tools, experience, and understanding the environment all have a role to play in these decisions.”

In our research, we compared four portfolios, each tracking the same ideal portfolio of a different target factor but rebalancing at three different frequencies: daily, monthly, and biannually. In each case, the daily rebalanced portfolio maintained a consistent exposure to the target factor, while the portfolios rebalanced monthly and biannually did not always keep pace with the factor’s changing composition.

We found that daily rebalancing led to much higher excess returns compared with portfolios that rebalanced at less frequent intervals. We also found that the efficacy of daily rebalancing was highly time dependent, and a significant amount of the outperformance came during periods of changing market leadership—when a bull market transitioned to a bear, or vice versa. This does not necessarily mean that managers should always try to rebalance daily, but having the flexibility to do so at the right time can be a great advantage.

These results show up across four widely available types of factor portfolios in the industry: momentum, value, quality, and a multifactor portfolio that equally weights these three factors. For each of these factors, the figures below illustrate the additional return a daily rebalanced portfolio would have earned relative to the less frequently rebalanced portfolios. These returns also reflect netting out conservative transaction-cost assumptions that are doubled during high-volatility periods like the dot-com bubble and the 2008 global financial crisis (GFC).

For each portfolio, we looked at the entire sample from January 1990 through August 2019, as well as three subperiods: the dot-com bubble, the GFC, and all other years excluding the GFC and the dot-com bubble. By breaking down the returns this way, we can clearly see that maintaining a consistent factor exposure by having the flexibility to rebalance daily provided excess returns over nearly all periods when compared with a fixed monthly or biannual rebalancing. The most significant excess returns were created during the dot-com and GFC periods, when the markets transitioned from one market cycle to another.

“What’s most significant here is that the data overwhelmingly shows the improvement in returns in excess of the estimated trading costs from rebalancing more frequently,” Khang said.

Khang and Jiannino said that allocators and advisors should be aware of the goals of a particular factor portfolio and make sure its portfolio manager is maintaining its factor exposures. Keeping up a factor exposure may be a slow-moving process in normal times, but during periods of heightened volatility like market-cycle transitions, maintaining desired factor exposures requires more agility.

Allocators and advisors also should be aware of the key decisions their factor portfolio managers have to make, including:

• What is the rebalancing schedule? The more flexible, the better.
• In what parts of the market are they getting exposure? Investors should get factor exposure from a broad market-cap spectrum, and not just through large companies, because factor exposure is often strongest in mid- and small-cap companies.
• How are they weighting companies to get this exposure? Rather than cap-weighting their exposures, portfolio managers should weight their securities by exposure to the factor.

“A fixed rebalancing schedule doesn’t really work with factor strategies given the way these assets have performed in the market,” Jiannino said. “Making sure you are maintaining exposures to factors is likely worth the additional transaction costs.”

• Keys to successful investing in actively managed funds, (video, issued March 2023)
• How inefficient is the 1/N strategy for a factor investor, (Journal article, issued February 2023)
• More information about Vanguard factor funds