Investors have spent decades hunting down ways to profit from stock market anomalies. But in recent years the idea of systematically skimming premiums from the stocks in the market most exposed to factors like size, value, momentum, quality and low volatility has reached new levels of sophistication. So-called 'smart beta' funds now focus entirely on squeezing profits out of factors like these. Look closer at their strategies and you'll see that they put considerable emphasis on routine rebalancing. For anyone following a rule-based, factor-focused strategy, it's worth knowing why this sort of portfolio management matters.
A matter of factor
First, a bit of background. Twenty-five years ago Eugene Fama and Ken French created a ground-breaking model of stock market returns using just three factors. Their research especially pinpointed size (small caps beat large caps) and value (cheap stocks beat expensive stocks) as consistent sources of outperformance. Since then further strides to improve the understanding of stock returns have been made by luminaries like Carhart, Asness, Lakonishok and others… with proof building that the following additional factors are highly correlated with future stock returns:
- momentum (the tendency for price trends to persist for between three months and a year)
- quality (firms with strong finances and robust business models beat weak, deteriorating junk stocks)
- low volatility (lower risk stocks have higher expected returns)
A number of the academics that originally researched these and other factors have since crossed into industry. They're either advising multi-million dollar funds, or running them. And one of the debates that they've been having in recent years is about the influence that rebalancing has on a factor-focused portfolio.
What rebalancing means
Rebalancing involves tweaking a portfolio so that it's weighted and diversified according to the original investment plan. Over time, even if you do nothing with a portfolio, its initial weights will eventually get out of whack as stock prices rise and fall. Traditionally, investors have been warned about this kind of drift because of the risk of being overexposed to individual positions.
In a factor-focused strategy - particularly one that uses value and momentum - there is an inherent risk of style drift without rebalancing. What that means is that value stocks that rise in price will eventually cease to offer the value premium any more. Likewise, momentum, which may last for up to a year, will eventually peter out. With the portfolio no longer exposed to those factors,…
