Factor Rotation vs. Equal Weight: A Comprehensive Analysis of Investment Strategies
Introduction
In the ever-evolving world of investment strategies, factor investing has gained significant traction over the past few decades. Two popular approaches within this realm are factor rotation and equal-weight strategies. But which one performs better in the long run? This article delves into an 18-year analysis comparing these two strategies, with a particular focus on how transaction costs and other real-world considerations impact their relative performance.
The Strategies
Before we dive into the analysis, let’s briefly define our two contenders:
1. Factor Rotation among Top 2: This strategy involves selecting the top two performing factors based on the past 12 months’ returns and rebalancing monthly. It’s a more active approach that aims to capitalize on the momentum of the best-performing factors.
2. Equi Weight of Factors: This strategy equally weights all factors, maintaining a constant allocation regardless of recent performance. It’s a more passive approach that benefits from diversification across all factors.
Methodology and Data
Our analysis spans 18 years of data, examining rolling returns over 3-year, 5-year, and 7-year periods. We used index data for various factors, as tradable instruments were not available for the entire period. This approach comes with some caveats, which we’ll discuss later.
We compared the performance of these strategies under three scenarios:
1. No additional costs
2. 1% annual cost applied to the Factor Rotation strategy
3. 2% annual cost applied to the Factor Rotation strategy
These cost scenarios aim to account for the higher turnover and potential tax implications of the more active Factor Rotation strategy.
Results
Let’s examine the results for each time horizon:
3-Year Rolling Returns
| Scenario | Equi Weight | Factor Rotation | Difference | Outperformer |
| — — — — — | — — — — — — -| — — — — — — — — -| — — — — — — | — — — — — — — |
| No Cost | 16.38% | 17.23% | 0.85% | Factor Rotation |
| 1% Cost | 16.38% | 16.23% | -0.15% | Neither |
| 2% Cost | 16.38% | 15.23% | -1.15% | Equi Weight |
5-Year Rolling Returns
| Scenario | Equi Weight | Factor Rotation | Difference | Outperformer |
| — — — — — | — — — — — — -| — — — — — — — — -| — — — — — — | — — — — — — — |
| No Cost | 15.97% | 16.78% | 0.81% | Factor Rotation |
| 1% Cost | 15.97% | 15.78% | -0.19% | Neither* |
| 2% Cost | 15.97% | 14.78% | -1.19% | Equi Weight |
*Note: At 1% cost, there’s weak evidence (p < 0.10) that Equi Weight might outperform, but it’s not significant at the 0.05 level.
7-Year Rolling Returns
| Scenario | Equi Weight | Factor Rotation | Difference | Outperformer |
| — — — — — | — — — — — — -| — — — — — — — — -| — — — — — — | — — — — — — — |
| No Cost | 16.18% | 16.83% | 0.65% | Factor Rotation |
| 1% Cost | 16.18% | 15.83% | -0.35% | Equi Weight |
| 2% Cost | 16.18% | 14.83% | -1.35% | Equi Weight |
Analysis and Implications
1. Performance without Costs: In an ideal world without transaction costs or taxes, the Factor Rotation strategy outperforms the Equi Weight strategy across all time horizons. The outperformance ranges from 0.65% to 0.85% annually, which is economically significant over long periods.
2. Impact of Costs: The introduction of costs dramatically changes the picture. With just a 1% annual cost:
— For 3-year periods, the strategies perform similarly.
— For 5-year periods, there’s a slight edge to Equi Weight, though not statistically significant.
— For 7-year periods, Equi Weight significantly outperforms.
3. Higher Cost Scenario: With a 2% annual cost applied to Factor Rotation:
— Equi Weight decisively outperforms across all time horizons.
— The performance gap widens as the time horizon increases.
4. Time Horizon Matters: The longer the time horizon, the more sensitive the Factor Rotation strategy becomes to costs. This suggests that for long-term investors, the simpler Equi Weight strategy may be more robust when real-world costs are considered.
5. Statistical Significance: The outperformance of Factor Rotation in the no-cost scenario is statistically significant across all time horizons (p-values < 0.05). Similarly, the outperformance of Equi Weight in the 2% cost scenario is also statistically significant.
Practical Implications for Investors
1. Cost Awareness: This analysis underscores the critical importance of considering all costs when evaluating investment strategies. What looks optimal on paper may underperform in practice when real-world expenses are factored in.
2. Simplicity vs. Complexity: The Equi Weight strategy, being simpler and likely incurring lower costs due to less frequent trading, becomes increasingly attractive as we account for realistic expenses. This highlights the potential benefits of simpler, low-turnover strategies in practical applications.
3. Time Horizon Consideration: Investors with longer time horizons should be particularly cautious about adopting complex, high-turnover strategies. The compounding effect of costs over time can significantly erode potential outperformance.
4. Risk and Consistency: While not directly addressed in this analysis, it’s worth noting that the Equi Weight strategy likely offers more consistent performance and potentially lower risk due to its broader diversification.
Caveats and Limitations
It’s important to note some limitations of this study:
1. Use of Index Data: We used index data rather than actual tradable instruments. Real-world implementation might face additional challenges.
2. Bid-Ask Spreads: Actual bid-ask spreads might differ from what’s implied in the index data, potentially impacting real-world returns.
3. Closing Prices Only: The analysis used only closing prices, which might not fully capture intraday trading opportunities or challenges.
4. Tracking Error: There could be tracking error if real-world securities were used instead of index data.
5. Tax Considerations: The impact of taxes, which could vary significantly between the two strategies, was not explicitly modeled beyond the general cost scenarios.
Conclusion
This comprehensive analysis reveals that while Factor Rotation among the top 2 factors can outperform an Equal Weight strategy in a frictionless environment, this advantage quickly disappears — and often reverses — when realistic costs are considered.
For practical implementation, investors should:
1. Carefully evaluate the total costs associated with any strategy, including transaction costs, taxes, and potential market impact.
2. Consider their investment time horizon, as longer periods seem to favor simpler, lower-turnover approaches.
3. Weigh the potential benefits of complex strategies against their increased costs and operational challenges.
4. Remember that past performance, even in detailed backtests, does not guarantee future results.
In the end, this study suggests that in the world of factor investing, the old adage might hold true: sometimes, less is more. The simpler, more cost-effective approach of equal weighting factors shows robust performance when real-world considerations come into play, challenging the notion that more active, complex strategies necessarily lead to better outcomes.
As always, investors should consider their unique circumstances, risk tolerance, and objectives when choosing an investment strategy. While this analysis provides valuable insights, it should be one of many inputs in the decision-making process.
Watch detailed YouTube video here:
— — — — — — — — — — — — — — — — — — — — — —
QuantX-Strategyzer: The Complete Guide to Quant Investing & Backtesting
https://bit.ly/JoinQuantX-Startegyzer
— — — — — — — — — — — — — — — — — — — — — —
Important Links
Youtube: https://www.youtube.com/@MomentumLab_IN
Twitter: https://x.com/MomentumLab_IN
