Choosing Factors: Not “Which?” but “When?”

Abstract

Equity factors such as value, size, and momentum have notoriously cyclical return patterns that may make them inappropriate investments depending on one’s time horizon. In this article, the author sizes the duration of these cycles and shows that cycle length varies considerably across factors. A simple rule of thumb emerges from this analysis: A factor should not be considered if the intended holding period is less than the cycle length. In other words, time diversification is a key consideration in choosing factors. He then uses a multiperiod optimization algorithm incorporating factor cycle lengths to select optimal factor allocations. As expected, the model tends to align factor cycle length and time to liquidation. That is, longer cycle factors were more prevalent in the optimal portfolio the longer the time to liquidation, and vice versa. These results add to the existing literature in helping to answer the question of which factor is best. Interestingly, the results suggest that we may be asking the wrong question—that we should be asking not which? but when?