Factor Portfolios: Turnover Analysis

What’s my Portfolio Churn?

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

SUMMARY

  • Factor portfolios have an annual turnover over more than 100%
  • The turnover rate varies substantially across factors
  • Decreasing the rebalancing frequency reduces turnover, but also risk-return ratios

INTRODUCTION

Some ETF investors claim that passive index products are superior to actively managed funds due to lower turnover and therefore less transaction costs. While this is partially true, most investors are unlikely to be familiar that indices such as the S&P 500 have a relatively high amount of turnover. The average tenure in the S&P 500 has decreased from 33 years in 1964 to 24 years in 2016, which implies an 8% turnover per annum, and is expected to shrink further. Stated differently, about half of the current members of the index will be replaced over the next 10 years, which is not in line with a buy-and-hold philosophy. In the factor investing space the high turnover of factor portfolios is often cited as a reason for the mediocre performance of live investible factor-based products compared to their theoretical backtesting. In this short research note we will analyse the turnover of common equity factors in the US.

METHODOLOGY

We focus on seven factors namely Value, Size, Momentum, Low Volatility, Quality, Growth and Dividend Yield as well as a multi-factor portfolio, which allocates equally to these. 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 based on the intersectional model, which selects the stocks in the intersection of the factors (read Multi-Factor Models 101). Only stocks with a market capitalisation of larger than $1 billion are included. Portfolios are rebalanced monthly and each transaction occurs costs of 10 basis points.

TRADABLE STOCK UNIVERSE

Before we analyse the factor turnover, it is worth providing details on the factor construction. Our universe of stocks in the US includes all companies with a minimum market capitalisation of $1 billion, which equates to approximately 1,700 stocks as of the first quarter of 2018. Portfolios are created by the top and bottom 10% of the stock market ranked by a factor,