Momentum Factor: Rebalancing Frequencies
The Momentum factor, which buys winning and shorts losing stocks, generated a poor performance over the period 2000 to 2018, which explains the negative risk-return ratios. The factor has a much higher turnover than the other factors as the stocks are selected exclusively on the 12-month price performance, which changes daily, and not fundamentals like the Value and Quality factors.
Investors therefore might expect that more frequent rebalancing is most favourable for this factor as it incorporates the latest price changes. However, the analysis below shows that this is not the case, which can partially be explained by higher transaction costs from more frequent rebalancing.
The impact of the rebalancing frequency on the Quality factor, which is defined as a combination of return-on-equity and debt-over-equity ratios, is heterogeneous. The factor definition is exclusively based on fundamentals, which means that the stocks in the long and short portfolios only change when earnings are released. It is therefore intuitive that the rebalancing frequency does not have a significant impact on this factor.
This short research notes highlights that the impact of the rebalancing frequency on a multi-factor and single factor portfolios is mixed. Weekly rebalancing is not advantageous to monthly rebalancing, but too infrequent rebalancing reduces the risk-return ratios.
Naturally transaction costs have an impact on the analysis and with continuously decreasing costs, more frequent rebalancing might become more attractive, although the benefits are likely to be marginal. The robustness of factor performance across different rebalancing periods is one of the advantages of factor investing.
This article was republished with permission from Value Walk.