Rebalancing Act

By: Bill DeRoche • July 24, 2019

Why flexibility is an important element when rebalancing a factor-based portfolio

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Most investors recognize the value in rebalancing their portfolios on a regular basis. After all, doing so can help rein in risk and generate extra return over time. But not everyone gets the degree and timing of it right, which can lead to outcomes that undermine the potential benefits.

This is especially true when it comes to factor-based investing, where the characteristics that define a security may change dramatically over time. While fluctuations in factor exposures are mainly random from day to day, it is crucial that investors plan for and adapt to longer-term shifts related to the erosion in information used to forecast future stock returns.

Also known as factor decay, this erosion is an unavoidable consequence of a dynamic market that can be anticipated to some extent by analysing average decay rates historically associated with factors such as momentum, value, quality, size and volatility. Often enough, however, actual rates of decay will deviate significantly from the mean and cannot be forecast in advance.

Fixed rebalancing frequencies and turnover levels, as a result, can be a great way to capture historical averages, but may miss the mark otherwise. As such, investors are better equipped to ensure factor exposures are aligned with ongoing intentions when they have the discretion and flexibility to rebalance and turn over a portfolio as needed.

Still, that’s only part of the battle. Investors must also decide whether the benefits of taking action outweigh the costs of doing so.  

In AGFiQ’s case, that decision is grounded in our quantitative models that optimize factor exposures but then is further enhanced when the science of portfolio management meets the art of portfolio management.

More specifically, we incorporate mean variance analysis to rank each security in a given universe based on the potential rewards and risks associated with them. Those with the highest scores are then overweighted in the portfolio and those with the lowest scores are underweighted.

This is a powerful framework that can rank securities on a daily basis – and therefore know how an “optimal” portfolio should be recomposed almost all the time.  And yet, herein lies one of the biggest challenges facing investors.

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The cost of rebalancing an actual portfolio this frequently would far outweigh the benefits in all but the most extreme scenarios. On the other hand, a rebalancing regime that is too infrequent can lead to unintended exposures that persist over extended periods of time and compromise the portfolio’s mandate.

Similarly, turnover levels need to provide an expected benefit that exceeds the cost of making the trades.

This dilemma can be addressed in large part by understanding why a stock or bond’s score might change in the first place. As noted already, “noise” is one big reason, but the more important cause is the rate of factor decay inevitable in each security.

A momentum stock, for instance, is impacted by daily price movements and, therefore, doesn’t usually exhibit its namesake characteristics for long. A value stock, meanwhile, is more influenced by quarterly earnings, not just daily prices, and tends to keep its spots longer. As such, momentum is commonly known as a high turnover factor, whereas value tends to require less frequent turnover.

Other factors, including volatility, size and quality, also have their own average rates of decay and fluctuation, using these estimates can be crucial in determining an appropriate rebalancing schedule. But whether that ends up being a quarterly rebalance with a turnover level of 25%, or something more or less frequent and of different magnitude, it can be dangerous to consider such a schedule as static. That’s because the actual decay in a security’s level of information rarely matches the average and, instead, tends to deviate from the mean more quickly or more slowly based on real-time circumstances.

In a multi-factor strategy, this can be further complicated by the dynamic interplay between factors. Correlations between momentum, value, volatility, size, and quality sometimes change, meaning the ability to get exposure to all of them is also subject to change. Therefore, If two or more factors move from correlated to highly uncorrelated over a short period of time, it may be necessary to rebalance out of schedule in order to avoid having negative (or not enough) exposure to one or more of the factors.

With all of this in mind, it’s important to have some way of monitoring the difference between the strategy’s optimal weights against their actual weights and then deciding how much of this gap can be tolerated. This could be as simple as creating a rule around what’s generally acceptable and, more often than not, these gaps are small enough to ignore and/or can be easily rectified by regular inflows and out.

But in those cases where the portfolio has deviated too much from the optimal and flows are limited, the best action to take is often a swift and timely rebalance to bring it back in line.

Bill DeRoche is the chief investment officer of AGF Investments LLC. He is a regular contributor to AGF Insights.

 

Commentaries contained herein are provided as a general source of information based on information available as of July 18, 2019 and should not be considered as personal investment advice or an offer or solicitation to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication; however, accuracy cannot be guaranteed. Market conditions may change and the manager accepts no responsibility for individual investment decisions arising from the use of or reliance on the information contained herein. Investors are expected to obtain professional investment advice.

AGFiQ is a collaboration of investment professionals from Highstreet Asset Management Inc. (a Canadian registered portfolio manager) and AGF Investments LLC (formerly FFCM, LLC). This collaboration makes-up the quantitative investment team.

AGF Management Limited (“AGF”), a Canadian reporting issuer, is an independent firm composed of wholly owned globally diverse asset management firms. AGF’s investment management subsidiaries include AGF Investments Inc. (“AGFI”), AGF Investments America Inc. (“AGFA”), Highstreet Asset Management Inc. (“Highstreet”), AGF Investments LLC (formerly FFCM LLC) (“AGFUS”), AGF International Advisors Company Limited (“AGFIA”), AGF Asset Management (Asia) Limited (“AGF AM Asia”), Doherty & Associates Ltd. (“Doherty”) and Cypress Capital Management Ltd. (“CCM”). AGFI, Highstreet, Doherty and Cypress are registered as portfolio managers across various Canadian securities commissions, in addition to other Canadian registrations. AGFA and AGFUS are U.S. registered investment advisers. AGFIA is regulated by the Central Bank of Ireland and registered with the Australian Securities & Investments Commission. AGF AM Asia is registered as a portfolio manager in Singapore. AGF investment management subsidiaries manage a variety of mandates composed of equity, fixed income and balanced assets.

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