FACTOR CONSTRUCTION: PORTFOLIO REBALANCING
Weekly, Monthly, Quarterly?
February 2018. Reading Time: 10 Minutes. Author: Nicolas Rabener.
- Factor portfolios do not benefit significantly from intra-month rebalancing
- However, too infrequent rebalancing leads to lower risk-return ratios
- The robustness of factor performance at different rebalancing periods is one of the advantages of factor investing
Creating factor portfolios requires investors to make a number of decisions regarding portfolio design and can be considered as much an art as science. The sorting metrics need to be defined, the stock universe, the top and bottom cut-off levels, and the rebalancing periods. The latter, i.e. how frequent the portfolio needs to be rebalanced, might seem trivial, but markets have gotten more efficient and quicker rebalancing might be advantageous. Academic research typically assumes quarterly or monthly portfolio rebalancing, which seems rather infrequent in the age of high-frequency trading. In this short research note we will analyse the impact of the rebalancing frequency on a multi-factor portfolio and four single factors.
In this research report we focus on four factors namely Value, Size, Momentum and Quality. The factors are created by constructing long-short beta-neutral portfolios of the top and bottom 10% of stocks of the US stock market. The multi-factor portfolio is comprised of the four factors and is created via the intersectional model, which selects the stocks in the intersection of the factors. Only stocks with a market capitalisation of larger than $1 billion are included and each transaction occurs costs of 10 basis points.
MULTI-FACTOR PORTFOLIO: REBALANCING FREQUENCIES
The chart below shows the performance of a long-short multi-factor portfolio in the US, which ranks stocks for the Value, Size, Momentum and Quality factors. E.g. the long portfolio contains stocks that are cheap, small caps, have shown a good relative performance over the last 12 months and rank highly on quality metrics. The portfolio is rebalanced at different intervals and we can observe that the profiles are almost identical in terms of trend. However, the portfolios with more frequent rebalancing, i.e weekly to monthly, show a consistent outperformance to portfolios that rebalance on a quarterly or semi-annual basis.
Investors might argue that a more frequent rebalancing adapts the portfolio quicker to company news and market changes, naturally at the price of more transaction costs. The multi-factor portfolio selects stocks based on the intersectional model, which means the stocks in the intersection of factors (please see this report for further model details Multi-factor Model 101). These stocks don’t rank particular high on a single factor, but rank highly on average across the factors, which results in a portfolio of stocks that does not change often as the multi-metric ranking process provides a degree of stability. The chart below exhibits the risk-return ratios of the multi-factor portfolio with different rebalancing frequencies. More frequent rebalancing generates higher ratios, albeit with only a marginal difference between weekly and monthly rebalancing.
VALUE FACTOR: REBALANCING FREQUENCIES
In addition to analysing the impact of the rebalancing frequency on the multi-factor portfolio we can also observe the changes for the individual factors. The chart below shows the risk-return ratios for the Value factor and highlights that the rebalancing frequency has a minor impact on the ratio. The factor is defined as a combination of price-to-book and price-to-earnings multiples, which only change significantly when corporate earnings are released. Given that listed companies in the US publish quarterly earnings, stocks in the long and short portfolios of the Value factor do not change too often.
SIZE FACTOR: REBALANCING FREQUENCIES
The impact on the Size factor, which is defined as buying small and shorting large companies, highlights a linear increase in the risk-return ratio with a decreasing rebalancing frequency. The results can be explained by portfolio construction, which requires companies to have a minimum market capitalisation of $1 billion. More frequent rebalancing leads to more companies being beneath the threshold, which then results in a higher turnover and more transaction costs. If we exclude transaction costs from the analysis, then the risk-return ratios do not show that less frequent rebalancing is more favourable.
MOMENTUM FACTOR: REBALANCING FREQUENCIES
The Momentum factor, which buys winning and shorts losing stocks, generated a poor performance over the period 2000 to 2018, which explains the negative risk-return ratios. The factor has a much higher turnover than the other factors as the stocks are selected exclusively on the 12-month price performance, which changes daily, and not fundamentals like the Value and Quality factors. Investors therefore might expect that more frequent rebalancing is most favourable for this factor as it incorporates the latest price changes. However, the analysis below shows that this is not the case, which can partially be explained by higher transaction costs from more frequent rebalancing.
QUALITY FACTOR: REBALANCING FREQUENCY
The impact of the rebalancing frequency on the Quality factor, which is defined as a combination of return-on-equity and debt-over-equity ratios, is heterogeneous. The factor definition is exclusively based on fundamentals, which means that the stocks in the long and short portfolios only change when earnings are released. It is therefore intuitive that the rebalancing frequency does not have a significant impact on this factor.
This short research notes highlights that the impact of the rebalancing frequency on a multi-factor and single factor portfolios is mixed. Weekly rebalancing is not advantageous to monthly rebalancing, but too infrequent rebalancing reduces the risk-return ratios. Naturally transaction costs have an impact on the analysis and with continuously decreasing costs, more frequent rebalancing might become more attractive, although the benefits are likely to be marginal. The robustness of factor performance across different rebalancing periods is one of the advantages of factor investing.
ABOUT THE AUTHOR
Nicolas Rabener is the Managing Director of FactorResearch, which provides quantitative solutions for factor investing. Previously he founded Jackdaw Capital, an award-winning quantitative investment manager focused on equity market neutral strategies. Before that Nicolas worked at GIC (Government of Singapore Investment Corporation) in London focused on real estate investments across the capital structure. He started his career working in investment banking at Citigroup in London and New York. Nicolas holds a Master of Finance from HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km Ultramarathon, Mont Blanc, Mount Kilimanjaro).