Equity Factors: Reducing Portfolio Turnover

Less Churn, More Returns?

November 2018. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Portfolio turnover of equity factors can be reduced significantly by trading more conservatively
  • However, reducing turnover does not necessarily increase risk-return ratios
  • It all depends on transaction costs

INTRODUCTION

Turnover in business tends to be positive or negative, depending on the context. Investors prefer businesses with high turnover in inventory to similar businesses with low turnover as it implies higher revenue growth. Inversely, investors prefer low to high turnover in staff as hiring and training new people tends to be expensive.

Turnover in stock portfolios is almost always seen as negative as each transaction incurs costs. Some factor-based strategies like Momentum exhibit high turnover ratios as significant amounts of the portfolio are rotated at each rebalancing date. However, new stocks are often just slightly more attractive than the old stocks from a factor perspective, which raises the question if the transaction was necessary. In this short research note, we will investigate the impact of reducing the turnover on common equity factor portfolios across markets.

METHODOLOGY

We focus on a universe of five factors namely Value, Size, Momentum, Low Volatility and Quality in the US, European and Japanese stock markets. The factor performance is calculated by constructing long-short beta-neutral portfolios of the top and bottom 10% of stocks ranked by the factor definitions, which are in line with academic and industry standards (please see our Factor Guide for the factor definitions). Only stocks with a minimum market capitalization of $1 billion are included. Portfolios are rebalanced monthly and each transaction incurs costs of 10 basis points.

REDUCING TURNOVER IN FACTOR PORTFOLIOS

Our universe in the US contains approximately 1,800 stocks as of 2018, which implies 180 stocks in the long and 180 stocks in the short portfolio. At each monthly rebalancing date, existing stock positions that no longer fulfill the criteria are replaced with new stocks. However, if a stock only slightly changed its factor rank, e.g. moved from rank 180 to 181, it likely has the same factor potency as before