Expert perspective
Why regular rebalancing is key to maximizing factor premiums
March 14, 2021
Vanguard's leading expert on factor investing, Antonio Picca and his team, recently researched the optimal rebalancing mechanism for long-only factor funds.
What the findings indicate
The findings may surprise some as it shows that, based on the last 30 years of factor-investing performances, 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 premiums, effectively doubling the historically observed premiums of many factors.
What's more, these findings indicate that to harvest factor premiums to their maximal potential, skill is needed on the part of the fund manager—an ability to tell the right moment to aggressively rebalance.
We asked Antonio Picca four key questions about this body of research.
Key points:
- The substantial factor premia documented over long periods of time have been historically realized over a small number of periods when outsized positive returns appeared in clusters. Typically, in these periods, market leadership changed as a bull market transitioned to a bear market, or vice versa.
- Maintaining a consistent factor exposure by having the flexibility to rebalance on a daily basis—instead of monthly or biannually like an indexed fund—would have delivered significantly higher factor premia, effectively doubling the historically observed premia in many cases. In particular, when daily rebalancing led to notable outperformances, the targeted factor's composition changed at a significantly faster pace than in normal times.
- Our findings indicate that harvesting factor premia to their maximal potential requires a skilled fund manager, who is dedicated and able to tell the right moments to aggressively rebalance from the other times.
It depends on who you ask. Gene Fama, for example, will tell you that factor investing is a purely passive endeavor. Whereas quantitative managers will tell you that it is a form of active investing. The truth is that factor investing straddles active and passive management.
Effective factor strategies seek to deliver a targeted factor exposure. To achieve this, they run a significant active risk against a market capitalization weighted benchmark, and frequently experience persistent out- or underperformances.
Despite this, people have grown to think of factor strategies as passive because the marketplace has been dominated by passive funds that are often anchored to a "factor index" that rebalances at most a few times in a given year. Beneath this passive façade, however, all factor funds are fundamentally active at their core.
Using the analogy of thrill-seeking adventures, we observe that factor investing is akin to surfing; a high-skill adventure. To achieve higher factor premia, factor investing requires active monitoring of the market environment, patience to wait until the wave of outsized returns finally arrives, and most importantly, the ability to decisively catch the wave to ride it from start to finish.
In our research, we compared three portfolios tracking the same factor "index" but rebalancing at different frequencies: daily, monthly, and biannually. The daily-rebalanced portfolio maintained a consistent exposure to the factor, while the other portfolios experienced exposure decay like indexed factor funds.
We found that maintaining a consistent exposure by rebalancing daily leads to much higher excess returns compared to portfolios that rebalance monthly or biannually. We also showed that the efficacy of daily rebalancing is highly time varying, and a significant amount of the outperformance was observed during periods of changing market leadership; when a bull market transitioned to a bear market or vice versa.
This means that managers might not want to always rebalance daily, but having the flexibility to do so is a great advantage.
Our results are robust across factors with different levels of turnover: momentum, value, quality, and a multifactor portfolio that equally weights the three aforementioned factors. Momentum is a fast-moving factor because it is affected by short-term returns. Quality, on the other side, only moves when companies report their financial statements. We chose these factors because they represent the set of factors that has become commonly available in the factor fund marketplace. In addition, all single factors we considered have undergone years of extensive research in the academic and practitioner literature. A process that consolidated insights into why the factor premium existed in the past and may persist into the future.
Sure. The figure below illustrates the returns of four separate long-only portfolios: momentum, value, quality and multi-factor. The returns reflect conservative, transaction-cost assumptions that are doubled during high-volatility periods like the dot-com bubble bust and the global financial crisis (GFC).
For each portfolio, we looked at the entire sample from January 1990 to August 2019, as well as three sub-periods covering the dot-com bubble, the GFC, and all other years that exclude the GFC and dot-com bubble. The excess returns created by daily rebalancing versus monthly rebalancing is noted in light blue. Whereas the excess returns created by daily rebalancing versus bi-annual rebalancing is noted in dark blue.
Breaking down the returns in this way demonstrates that maintaining a consistent factor exposure by having the flexibility to rebalance daily provides excess returns over nearly all periods when compared to a fixed monthly or bi-annual rebalancing.
The most significant excess returns were created during the dot-com and GFC periods when the markets transitioned from one cycle to the next.
Daily rebalancing outperforms monthly and biannually rebalanced portfolios
D-M = Daily versus monthly rebalancing
D-B = Daily versus biannual rebalancing
Momentum
Value
Quality
Multifactor
Notes:
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Sources:
Vanguard. The portfolios were constructed using U.S. equity universe data underlying Axioma's Risk Model AXUS4 (Axioma). This universe of securities largely overlaps with Russell 3000. The three single-factor portfolios were equally weighted the top 30% of securities by factor score as determined by Axioma. The multi-factor fund was constructed first by averaging the factor scores of momentum, value, and quality at the individual security level, which creates a cross section of composite multifactor scores. Based on this composite score, we then selected the top 30% of securities and equal weighted them. The portfolios tracked the same signal portfolio by rebalancing daily, monthly, and biannually, 30 bps per transaction volume for all trading; in addition, for extended periods with elevated volatility—notably around the dot-com bust (1999–2004) and the great financial crisis (2008–2009)—we double the trading cost assumption to 60 bps per transaction volume.
The concept of factors is simple. However, factor investing is not easy because factor returns can be quite volatile over short periods and can go through long stretches of underperformance. Successful factor managers should be able to maintain a strong and consistent factor exposure over time.
A strong factor exposure requires conviction and the willingness to run significant active risk against the market. Maintaining consistent exposure requires not only patience—to wait until the factor is in action—but also well-timed agility to follow the signal aggressively when the return environment does present itself.
Going back to the surfing analogy, a skillful factor manager is like a master surfer who waits for the big wave. Even though it requires a whole lot of dedication, the surfer endures the passing of time patiently waiting for the big wave to appear. However, if and when the big wave does appear, how this surfer has prepared for this once-in-a-decade opportunity will be fully on display.
A well-prepared master surfer will ride the wave from start to finish, whereas others may wait on the side line for too long and catch only the tail end of the wave; a wave that may not return for another decade.
Notes:
- For more information about Vanguard funds or Vanguard ETFs, visit vanguard.com 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 principal. 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.
- Prices of mid- and small-cap stocks often fluctuate more than those of large-company stocks.
- 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.
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