Factor investing series

Tactical factor tilts to express investment views

| 14 November 2017

Satrix factor series: “Practical applications of factor investing”

Part 6/10: Tactical factor tilts to express investment views

Client level of adoption/allocation:

Client level of adoption/allocation

Factor investing has the ability to empower consultants, multi-managers and advisors to build client portfolios simply and efficiently.

From 1) the transparent manner in which factor portfolios are systematically constructed, to 2) the capability of building tailored investment outcomes with greater diversification and predictability, to 3) the low fees, to 4) the reliability in consistently delivering a specific investment philosophy. Factor investing is beginning to revolutionise the investment industry.

While the potential impact of factor investing is transforming in nature, the level of adoption by clients varies by degree of simplicity, from ‘not allocating’ to ‘sophisticated allocation’. In this series we aim to highlight all applications of factor investing across this continuum.

This article is the sixth in our series of articles aimed at discussing practical ways to employ the power of factor investing. In our previous article, we discussed how to incorporate a factor-based equity portfolio within a multi-asset solution.

In this article, we discuss employing factor investing in a more tactical manner, in order to express an investment view in your portfolio.

There are typically two frameworks that one can use to inform tactical investment decisions around factors. The first is based on fundamental information, drawing on relative valuations and/or price momentum. The second approach, which we outline in this article, uses economic cycles to inform the short to medium term prospective returns of factors – in our view, an arguably more intuitive and objective approach.

We used an output gap[3] as an economic cyclical indicator, and divided this indicator into four distinct and successive phases depending on the direction of the indicator, as well as whether the indicator was above or below economic trend growth. Our aim is to form an understanding of how each factor behaves during various economic cycles, and use this framework as a basis to tactically shift portfolio factor exposures.

Figure 1: Stylised economic cycle using de-trended output gap

Stylised economic cycle using de-trended output gap

3 We used the SA Manufacturing PMI as a proxy for economic activity, and applied a Hodrick–Prescott (HP) filter over the raw data to express the business cycle around a dynamic trend.

Our results are fairly intuitive, and summarised in Figure 2 below. We not only highlight which single factors performed best and worst, but which blend of factors is optimally suited to each cycle.

Average excess returns (relative to SWIX) for single and blended factor portfolios for different South African economic cycles (2001 to 2016)

During the Contraction phase of an economic cycle, growth slows down and equities typically do poorly compared to bonds (this is because interest rates are being cut in this phase). It therefore makes sense that Low Volatility and Quality strategies would be more successful, as investors look for defensively-orientated shares. As the economy transitions to Recovery phase and interest rate cuts take effect, equities tend to perform well versus bonds. But because the market is still cautious, Quality is preferred to Low Volatility as a strategy. Thereafter, as the economy gains traction and shifts into Overheat, investors move into Value and Momentum strategies, which represent the more cyclical equity strategies. Lastly, during the Hard Landing phase, a more diversified blend of factor portfolios tend to perform well, with the market starting to position itself for a defensive turn.

We feel it is important to bring to clients’ attention the risks associated with using an ‘economic cycle’ approach to tactically allocating between factor exposures. These include the risk that historical relationships remain intact along with the well-documented risk of trying to accurately time the next economic cycle.

For more information on this topic or further details on our analysis, please feel free to contact us directly.

In our next part in the series, we discuss the application of incorporating ESG and Responsible Investing themes into your portfolios through factor investing.

Watch this video for tactical factor tilts to express investment views by head of portfolio solutions at Satrix, Jason Swartz.

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We used the SA Manufacturing PMI as a proxy for economic activity, and applied a Hodrick–Prescott (HP) filter over the raw data to express the business cycle around a dynamic trend.