A Risk-Oriented Model for Factor Rotation Decisions

Keith L. Millera,, Hong Lib,, PhD, Tiffany G. Zhou c,, and Daniel Giamouridisd,, PhD
a

Managing Director, Head, Global Quantitative Research, Citigroup

388 Greenwich Street New York, NY 10013 Fax: +1 (212) 816 3144 Tel: +1 (212) 816 2285 E-mail: keith.l.miller@citi.com
c

Managing Director, Global Quantitative Research, Citigroup Tel: +1 (212) 816 1844 E-mail: hong.li@citi.com

Vice President, Global Quantitative Research, Citigroup Tel: +1 (212) 816 4659 E-mail: tiffany.zhou@citi.com

Assistant Professor, Department of Accounting and Finance, Athens University of Economics and Business, Athens, Greece Athens University of Economics and Business Department of Accounting and Finance 76 Patission Street 10434 Athens, Greece Tel: +30 210 8203925 Fax: +30 210 8203936 E-mail: dgiamour@aueb.gr Please indicate affiliation as: Daniel Giamouridis is an assistant professor in the Department of Accounting and Finance at Athens University of Economics and Business in Athens, Greece; a senior visiting fellow in the Faculty of Finance at Cass Business School, City University in London, UK; and a research associate at EDHEC-Risk Institute in Nice, France.

Electronic copy available at: http://ssrn.com/abstract=2159301

Abstract
We develop a factor rotation model that is suitably tailored to accommodate severe market conditions and largely to-date neglected phenomena, like factor crowdness, macroeconomic risks (concentration), and sudden factor reversals. Our model uses classification tree analysis on a number of fundamental factor characteristics as well as novel measures we develop through detailed risk attribution analysis of the factor. The model we propose provides significant value when applied in a single-factor setting. The outperformance of our model is even more pronounced when it is used in a dynamic multi-factor setting, where the risk/reward more than triples and the hit ratio improves by about 15% relative to the equally weighted model.

Electronic copy available at: http://ssrn.com/abstract=2159301

Introduction
One principal decision in equity portfolio management is the determination of portfolio factor tilts. That is, given equity markets are segmented segments comprise stocks with common characteristics such as beta, size, value, growth, quality, momentum, among others and stocks from different segments realize different average risk-adjusted returns for extended periods, it is critical for an equity portfolio manager to be able to time a segment of the market. This facet of the investment decision process is typically referred to as style rotation or factor timing. Factor timing has for long attracted the interest of academics and practitioners. As a concept it is a variant of market timing between cash and equities which was first studied by Sharpe (1975). Kester (1990) expanded the scope of market timing strategies by including small firms, while subsequent works by Case and Cusimano (1995) and Sorensen and Lazzara (1995) among others study tactical allocations to value and growth stocks. Ahmed, Lockwood, and Nanda (2002), Arshanapalli, Switzer, and Panju (2007), Bauer, Derwall, and Molenaar (2004), Desrosiers, et al. (2006), Kao and Shumaker (1999), L'Her, Mouakhar, and Roberge (2007), Levis and Liodakis (1999), and Miller et al. (2012) are indicative studies that have more recently documented significant added value from over-weighted positions in the outperforming segment during the appropriate periods. Quantitative approaches for factor allocation decisions are broadly speaking based on two building blocks. One building block is the set of variables that are assumed to explain the time variation of style returns. The second block is the model used to facilitate the relationship between the explanatory variables and the style return. The models (and variables) that have thus far been proposed can be classified in four broad categories: a) models based on return momentum (see, e.g. Clare, Sapuric, and Todorovic, 2010, Chen and De Bondt, 2004), b)
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multivariate regressions based on economic fundamentals, business cycle variables, or predictors to the stock market or aggregate fundamentals (see, e.g. Copeland and Copeland, 1999, Lucas, van Dijk, and Kloek, 2002), c) logit multivariate models using similar variables as the multivariate linear models (see, e.g. Bauer, Derwall, and Molenaar, 2004, Levis and Liodakis, 1999), and d) non-parametric techniques such as the Classification and Regression Decision Tree (see, e.g. L'Her, Mouakhar, and Roberge, 2007). Miller et al. (2012) develop a hybrid model that relies on the Classification and Regression Decision Tree approach but also on multivariate predictive regressions. Recent episodes in financial markets however suggest that these approaches, even the most sophisticated ones, might not be perfectly suited to tackle these, undoubtedly, unprecedented events.1 Our investigation of the events reaches three main conclusions that are particularly important for factor rotation decisions. Our first conclusion suggests that there can be instances when the number of similarly constructed portfolios increases dramatically, i.e. factor portfolios become highly correlated and crowded, and this in turn induces significant systemic risk. Our second conclusion, which is our main motivation, is that there may be periods when macroeconomic factors become the most important drivers of style portfolio returns. Given the global reach of these factors, this represents risky periods. Further we observe that most stock selection factors have experienced very high volatility and frequent reversals in performance over the last few years. Factor/style rotations have been compressed into shorter periods of time. We conclude that understanding the systematic risk of factors is important for predicting their future performance.

Lo (2012) provides a comprehensive review of books written about the recent crisis while an earlier paper by Khandani and Lo (2011) provides a more focused analysis for quantitative equity investors. 4

We argue that modern style rotation decision models should provide the best possible account for these conclusions. The model we develop in this article integrates measures that are suitably tailored to capture events of risk concentration on macroeconomic (or other) factors. We apply our model with shorter time rebalancing to capture potential short-term factor reversals and overall conclude that the framework we propose adds significant value. Although independently developed, our framework encompasses the premises identified as critical for contemporary active quantitative portfolio management in a recent thought provoking work by Li and Sullivan (2011). Before we proceed with the detailed presentation of our approach, in the next Section we present the empirical analysis that led us to the conclusions we refer to earlier and, ultimately, to the development of our dynamic factor rotation model.

What have we learned from recent market episodes?

The recent history of quantitative equity investing has experienced a series of unfortunate events. Like other investment processes and styles, quantitative strategies regularly experience periods of underperformance. What makes the recent past unique and particularly painful is the extended period of underperformance. Over the last few years, the underlying causes of underperformance have, to some degree, varied. In this Section we explore the nature of the recent events to further our understanding on the fundamental causes of these episodes and build our priors as to what directions should be pursued for improving factor rotation decision models. We conduct our investigation with four common quantitative equity factors, namely Momentum, Earnings Revision, Book Yield, and Earnings Yield. These factors represent long/short portfolios of stocks. They are constructed based on quintile ranks of the S&P 500 stocks on the respective factor, and equal weighting. The Momentum factor is a portfolio that holds the top quintile of S&P 500 stocks ranked with respect to their past 12 months (excluding last month) performance

and sells short the bottom quintile. The Earnings Revision factor comprises stocks quintiled with respect to their 4-week change in FY1 estimates. Book Yield and Earnings Yield are portfolios constructed on the basis of the firms Book-to-Price and Earnings-to-Price ratios respectively. Khandani and Lo (2011) use similar quantitative equity factors in their analysis (i.e. Book-toMarket, Earnings-to-Price, Cashflow-to-Market, Price Momentum and Earnings Momentum). The 2007 Liquidity Crisis. The long-term success of many quantitative strategies brought about their widespread adoption by many investors including hedge funds. The sustained low volatility and low return environment resulted in greater use of leverage. Leverage combined with the commonality of many quant strategies made this a crowded trade (see also Li and Sullivan, 2011). Losses in other strategies in other asset classes induced liquidation of equity-marketrelated strategies. This in turn resulted in the simultaneous failure of what are normally uncorrelated stock selection factors. Brunnermeier (2009) and Brunnermeier and Pedersen (2012) formalize this interpretation with the concepts of the loss spiral and the margin/haircut spiral. We thus hypothesise that measures of crowdness should be associated with the failure of stock selection factors and hence have a negative impact on factor returns. To validate this hypothesis we conduct a factor short-interest analysis. We consider short interest as a proxy for measuring factor crowdness. We expect that the extent to which similar quantitative equity market portfolios are constructed in the market, will be reflected on the amount of stocks shorted given the nature (i.e. long/short) of these strategies. Hwang and Liu (2012) adopt a similar approach to infer investors involvement in certain anomalies. For

economy of space we present in Figure 1 results only for the Momentum factor (results for all other factors are available upon request). Figure 1 indicates the rank correlation between short

interest ratios, defined as short interest outstanding divided by shares outstanding, and price momentum rankings from 1995. [Figure 1 about here] An increasingly negative correlation indicates that there is growing short interest in lower momentum stocks and shrinking short interest in higher momentum stocks. This could signal a strong and perhaps overly bullish view on the prospects for high momentum stocks and hence suggest the strategy is becoming crowded. The evidence in Figure 1 suggests that this correlation measure has been constantly trending downwards in 2007 and has reached its full period historical low in late 2007. We reach similar conclusions when we examine rank correlations for Earnings Revisions and Book Yield (in 2008 in particular). This pattern is less pronounced for Earnings Yield. The overall evidence suggests that the 2007 episode was likely a manifestation of systemic risk due to extensive investment in similar quantitative equity portfolios. Khandani and Lo (2011) also document that the Quant Meltdown of August 2007 was the combined effects of portfolio deleveraging and a temporary withdrawal of market-making risk capital using transaction data analysis. 2008: Simultaneous Failure of Factors in the Face of a Worsening Credit Crisis. With much of the deleveraging having already occurred in 2007, quantitative strategies continued to struggle, especially globally in 2008. Over the course of 2008, the simultaneous failure of value and momentum factors occurred on multiple occasions. During these moments, the credit sensitivity of value factors was exposed while concerns around global economic growth negatively impacted momentum factors. During this period, both fundamental and quantitative investors struggled. Therefore we argue that the macroeconomic regime can under certain market conditions be a significant determinant of factor return. This is evident in our investigation. We conduct risk

analysis of the factors and measure the degree of total factor return variation that is explained by distinct broad risks, i.e. macroeconomic, market/sector, style/size, and idiosyncratic. In this Section we focus on the results of this investigation. We provide details of our risk analysis approach later in the text. [Figure 2 about here] Figure 2 illustrates select results of this analysis. The top graph illustrates the risk decomposition of the factor. In the bottom two graphs, the bars represent the net betas to each risk factor and the line represents the underlying risk factor. Panel A of Figure 2 shows that the portion of Momentum risk attributable to macroeconomic risk factors almost doubled during 2008 and 2009. Towards the end of the first half of 2008, Momentum presents with increasingly positive oil exposure (during a period when oil prices rose from $75 to above $140). These positive oil exposures resulted in a significant performance drag as oil prices collapsed afterwards. Fortunately, the negative impact of falling oil prices was somewhat offset by a defensive credit exposure, which benefited from widening credit spreads as the global financial crisis intensified. Panel B of Figure 2 suggests that at times over the last few years of the sample, macroeconomic risks have become a substantial part of the total risk of Earnings Revision. It also illustrates the variation in the factor exposure to oil prices and credit spread over time. The evidence we gather from this analysis overall suggest that macro risk and risk concentration is an important determinant of factor performance. The Risk Rally of 2009 and the better-than-expected performance of 2010-2011. Since March 2009, previously beaten down stocks have rallied strongly with the improving economic outlook. Specifically, low price-to-book, low price-to-sales, high CAPM beta stocks have posted very strong performance while earnings revisions and long-term price momentum, and

profitability strategies have significantly underperformed. Table 1 illustrates the performance of the four factors we consider in our analysis. Similar patterns are observed in unreported analysis for the rest of the factors we examined. Rank correlations between factors have been largely dynamic. Quantitative strategies were not well positioned for this low quality risk rally. Common risk exposures to oil in 2008 as well as common risk exposures to credit in 2009 are the main reasons why the factors failed simultaneously. While quantitative investors had de-risked over the previous two years, many still underperformed due to the negative correlation between value and momentum, which led to an underweighting of the highest beta stocks. In 2010-2011 we saw a marked improvement in performance compared to the performance in the 2007-2009. That said, 2010-2011 also saw several significant reversals in factor performance, as is evident in Table 1, which left most investors with near-benchmark results. This evidence overall suggests that factors have been very dynamic and may exhibit strong reversals in certain market regimes. [Table 1 about here] In 2012 we observe significant increase in the macroeconomic risk portion of total risk. For example, for momentum, the macro portion of risk has risen above 70%, which represents a 13year high. In summary our investigation reaches three main conclusions that are important for making educated style rotation decisions. First, that there can be instances when the number of similarly constructed portfolios increases dramatically, i.e. factor portfolios become highly correlated and crowded, and this in turn induces significant systemic risk. Second, that there may be periods when macroeconomic factors become largely important drivers of style returns. Given the global reach of these factors this represents risky periods. Third, that factor/style rotations have been compressed into shorter periods of time. Understanding the systematic risk of factors is extremely

important for predicting their future performance. We therefore propose integrating these ideas in the context of style rotation for the first time in the literature.

A risk-oriented factor rotation model

We structure the presentation of the proposed model as follows. First we discuss the variables that we consider as relevant for predicting factor returns. Next, we discuss the statistical technique that we use to associate the hypothesized relevant variables with subsequent factor returns. The predictive variables The set of independent variables we propose comprises two groups of variables. The first group consists of variables that measure the fundamental characteristics of factors. The second group comprises macroeconomic and market exposures of factors. These are all combined in a predictive model which we discuss in the subsequent sub-section. Hence our approach is able to capture characteristics as well as betas which have both been found in numerous studies to explain the cross-sectional variation in expected stock returns (see, e.g. Chordia, Goyal, and Shanken, 2012). We measure the fundamental characteristics of the factors through aggregate, i.e. bottom-up, measures of mainly valuation, growth, momentum, and risk. Our variable is then the relative distance of the bottom-up measure of the factor top portfolio vs. the factor bottom portfolio. To give an example, one of our variables is the factor relative book-to-price. This is simply the equally-weighted book-to-price of every stock in the top portfolio of the factor, e.g. the S&P 500 stocks in the top quintile of the price momentum factor, divided by the equally-weighted book-toprice of every stock in the bottom portfolio of the factor, i.e. S&P 500 stocks with the lowest 20%

10

of price momentum. The full set of fundamental characteristics includes the earnings yield, earnings growth rate, return on equity, dividend yield, historical volatility, momentum, earnings revisions, forward earnings yield, and market beta. Macroeconomic and market exposures of style returns are obtained from Citis US Risk Attribute Model (USRAM hereafter). The USRAM is a highly regarded risk analysis model that was first introduced in 1989 and has since been widely used by equity portfolio professionals. It is a macroeconomic time series factor model, which can be represented by the following equation for an individual stock i:
ME ME EM EM rit = ai + bij Fjt + bij Fjt + biS Ft S + eit j j

(1)

where:

rit = ai =

the total return of the stock during period t, the expected total return of the stock when all of the factors equal zero; a constant component of the stock return that is independent of both the factors and the period,

ME Fjt =
ME bij = EM F jt = EM bij =

the realization of the macroeconomic factor j during period t, the sensitivity of the stock to macroeconomic factor j, the realization of the equity market factor j during period t, the sensitivity of the stock to equity market factor j, the sector (the stock belongs) factor during period t, the sensitivity of the stock to its sector factor, the unsystematic (idiosyncratic) component of the styles total return that is independent of the factors during period t.

Ft =
S

biS =
eit =

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The macroeconomic factors of the model include: Inflation shock, measured as the actual vs. consensus expectation of monthly change in CPI, long-term interest rates, which are proxied by the 10-year US Treasury note yields, short-term interest rates, measured as the 3-month US Treasury bill yields, credit spread, which is the yield spread between Citi High Yield index and US 10-year note, oil price, that is the price of WTI benchmark crude oil, and dollar exchange

rate, which is measured as the Bank of England trade-weighted effective rate US dollar index.
The market-based risk factors comprise: market, the S&P 500 Index returns, small cap premium, the return spread of Russell 2000 index vs. S&P 500 Index, growth/value premium, the return spread of S&P 500 Growth Index vs. Value Index, and sector, the S&P 500 GICS sector returns. Intuitively the USRAM model can be viewed as a Fama and French (1993) three-factor model augmented with macroeconomics risk factors. It nests many of the variables proposed by Li and Sullivan (2011) as those that quantify big-picture issues. All market-based risk factors are orthogonilized with respect to the macroeconomic factors. Our factor return explanatory variables are estimates of the betas from equation (1) when it is applied to equity style (as opposed to single stock) returns. We also use as explanatory variables the variance of certain groups of factors as a fraction of the total return variance of the style. We provide more details on USRAM in the Appendix where we also show evidence that macroeconomic risk has recently become extremely important and in particular has accounted for more than 50% of the total explained risk in 2010-2012. The model The model we develop uses classification tree analysis to determine a forecast. Classification decision tree analysis (DT hereafter) is a multivariate statistical technique that explores conditional relationships between a dependent variable and a set of explanatory variables.

12

Sorensen, Miller, and Ooi (2000) provide a very detailed discussion of the DT methodology. Miller et al. (2012) find that the DT approach - as an element of a multiple predictive regression model - is largely successful in the context of size rotation. The DT statistical technique examines the historical values of a set of variables and determines the subset that has the greatest power to explain the one period ahead Information Coefficient2 (IC hereafter) of a factor. Using data for the period we examine we find that in many instances macroeconomic variables as well as variables related to the percentage of total factor return variation explained by a group of factors had the greatest explanatory power in the classification tree model. The DT analysis also determines the optimal sequence for screening with these variables, as well as the optimal screening criteria. Figure 3 depicts a complete decision tree estimated for

Momentum (Panel A) and Earnings Revisions (Panel B). Our model found that (see Panel A of Figure 3) if the fraction of the total return variance of the Momentum factor that is explained by the Size risk factor was above the eightieth percentile of its historical values (where the first percentile contains the lowest historical values) at the end of a month, then firms in the bottom quintile of past 12 months (excluding last month) performance were more likely to outperform their top quintile counterparts during the next month (Reversal). However, if this condition held

but the Momentum style (Growth/Value) slope was below the 34th percentile of its historical
values, then the bottom quintile of past 12 months (excluding last month) performance were more likely to underperform their top quintile counterparts in the next month (Momentum). Similarly we found that (see Panel B of Figure 3) the Earnings Revision factor performance depends on the fraction of the total return variance of the factor that is explained by the Style risk factor. It is further conditional on the total return variance of the factor that is explained by macroeconomic
The Information Coefficient measures the cross-sectional correlation between the security retun forecasts coming from a factor and the subsequent actual returns for securities. 13
2

risk factors. Proceeding in this manner, the model estimates a complete decision tree whose path is determined by applying a specific if-then rule at each branch. Thus, the DT analysis allows us to explore nonlinear relationships, measure the interactions among variables, and capture the conditional relationships between factor performance and the explanatory variables. [Figure 3 about here] Advantages of the model The models most important novel element is the integration of systemic risk variables in the set of independent variables. Recent evidence suggests that systemic risk measures are important for market timing purposes (Kritzman et al., 2011) as well as for identifying instances of increasing likelihood of market crashes (Berger and Pukthuanthong, 2012). Moreover, Khandani and Lo (2011) argue that the Quant Meltdown of August 2007 was largely a consequence of systemic risks posed by the hedge-fund industry. Our model tackles two different facets of systemic risk.3 First, the perspective of a likely crowded trade; and second the perspective of macroeconomic risk concentration. To best measure the former we would ideally have liked to use direct measures4 or even short interest data. Unfortunately, these data do not currently present with sufficient history for our analysis. We believe that particularly our variables that measure the fraction of total return variation of a factor explained by a (group of) factor(s) provide an indication of a crowded traded. It is in the spirit of Pojarliev and Levich (2011) who provide a measure of crowdness that is based on the sensitivities of a large cross-section of individual manager returns on common forex related factors. We measure macroeconomic risk concentration through the fraction of total return
3 Bisias et al. (2012) in their comprehensive survey of systemic risk analytics argue that systemic risk is complex and adaptive and hence more than one measure is needed to capture it. 4 A direct measure could involve transaction data in light of the insights of Khandani and Lo (2011).

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variation of a factor explained by macroeconomic variables. Our variables provide stronger economic justification relative to Kritzman et al. (2011) and Berger and Pukthuanthong (2012) who rely on Principal Component Analysis, and are more suitably tailored for factor rotation decisions. We are not aware of any other study that is concerned with the impact of increased systemic risk in the context of factor rotation although as we discuss earlier it is extremely important. Another critical aspect of the model we propose is the actual statistical technique that we use to facilitate the relationship between the predictive variables and the Information Coefficient of the factor. L'Her, Mouakhar, and Roberge (2007) highlight that parametric approaches, i.e. predictive regressions or logit models, are attractive for the reasons that they are not hard to implement/estimate, identify a specific correlation structure between the predictive and the predicted variables, and in most instances use parsimonious models. However they suggest that parametric models have inherent limitations due to the restrictive distributional assumptions, the linear functional forms which are also not a priori known, and the sensitivity to outliers. Kao and Shumaker (1999) also stress that regression analysis is based on stringent assumptions. The DT approach on the other hand lets the data determine the structure of the variable association, is not subject to strict assumptions of linearity and normality, and is robust in handling outliers. This is an important improvement also over measures such as the Absorption Ratio (Kritzman et al., 2011) or the Fragility Index (Berger and Pukthuanthong, 2012) which, although effective in measuring systemic risk, maintain a fixed structure and rely on some ad-hoc assumptions.5 L'Her, Mouakhar, and Roberge (2007) however stress that the DT approach bears significant risk of

Kritzman et al. (2011) for example fix the number of eigenvectors at approximately 1/5th the number of assets in their sample. 15

over-fitting, and may in some cases yield relations that are contrary to theory or intuition, and are generally very data-consuming.

Empirical analysis
Our empirical analysis is applied with stocks from the S&P 500. We use monthly data from December 1978 to December 1998 to fit our model. The model was recalibrated on a monthly basis using an expanding window. Our out-of-sample analysis covers the period January 1999 to August 2012. To tackle the dynamic behaviour of factors we rebalance the factor portfolio monthly. We apply three trading schemes. Our baseline model (Baseline) is a portfolio strategy that holds stocks in the top quintile of the factor and shorts stocks in the bottom quintile of the factor, i.e. a constant bet on the factor. In terms of our rotation models, we test two versions. One that buys the top quintile and sells the bottom quintile if the DT forecast is positive, and 0 if the DT forecast is negative (Active). And a second, that buys the top quintile and shorts the bottom quintile if the DT forecast is positive, and buys the bottom quintile and shorts top quintile if the DT forecast is negative (Aggressive). Contrasting these three trading approaches helps us determine the incremental value of our model to predict future factor returns. Single factor evidence In Table 2 we present a number of performance metrics that will help us conclude whether the model we propose adds value. We present the results relating to the analysis of the Momentum factor in Panel A, Panel B depicts the performance metrics for the Earnings Revision factor, and Panel C and Panel D tabulate the results for Book Yield and Earnings Yield respectively. We overall conclude that the proposed methodology adds significant value for single factor rotation. For all the factors we examine the Active and Aggressive models that rely on

16

predictions of the proposed model largely outperform the Baseline model across literally all metrics. In particular, the Baseline strategy produces average annualized returns that are not significant for any of the four factors examined. In sharp contrast the respective average annualized returns produced through the Active trading scheme are highly significant for Book Yield (p-value=0.01) and also for Earnings Yield (p-value=0.06). The returns of the Aggressive strategy are largely significant for Earnings Revisions (p-value=0.04), Book Yield (p-value=0.01) and Earnings Yield (p-value=0.03) and at the margin for Momentum (p-value=0.14). The Active and Aggressive model compare favourably in terms of risk/reward, hit ratio, average return when the prediction is correct (as well as when it is not correct) relative to the Baseline model. The bottom two rows of Table 2 suggest that the DT model (which is the basis of both the Active and the Aggressive schemes) passes the Henrikson and Merton (1981) non-parametric (a p-stat higher than 1 indicates that the model has genuine predictive ability) and parametric tests for market timing. Moreover, a possible criticism for the DT model, that it requires more frequent switches, which in the context of portfolio management translate into higher transaction costs, does not seem to be a concern given the relatively small number of switches we report. Statistical significance for the mean is tested with a t-test. The statistical significance of the return per unit of risk ratio is tested on the basis of 10,000 bootstrapped samples from the strategies original return sample. [Table 2 about here] Dynamic factor weighting model In this subsection we illustrate how the proposed model can be used in a setting that is more relevant for equity portfolio managers. From that perspective, what is critical is a process that combines multiple stock level signals in the portfolio construction process. We propose a scheme

17

that is based on the insights we provide earlier. Our active decisions in the multi-factor setting are based on dynamic weighting that depend on the predicted ICs. In particular we term Active Dynamic a strategy that assigns double weights to positive IC factors relative to the negative IC factors. We also term Aggressive Dynamic a strategy that uses equal-weighting of positive IC factors only, and zero if all four factors have negative ICs. We benchmark these strategies against a Baseline Multi-Factor approach that uses equal-weighting across the four factors. [Figure 4 about here] In Figure 4, we show the historical monthly performance of the models from January 1999 through to August 2012. We plot the cumulative total return index level of the portfolios obtained through the Baseline Multi-Factor, the Active Dynamic, and the Aggressive Dynamic approaches. We assigned a value of 100 to each index at the end of December 1998. The results suggest that the Aggressive Dynamic approach with terminal index of 344 outperforms both the Active Dynamic and the Baseline Multi-Factor, which present with terminal values of 200 and 123 respectively. The increase in terminal wealth of the Active Dynamic and the Aggressive Dynamic models over the Baseline Multi-Factor is of the magnitude of 72% and 180% respectively. [Table 3 about here] In Table 3 we present several performance metrics that overall provides strong support for the dynamic factor rotation model we propose. The Active Dynamic model outperforms the Baseline Multi-Factor in terms of average arithmetic annualized return by almost 4% per year. The outperformance of the Aggressive Dynamic model over the Baseline Multi-Factor is about 8% per year. Comparing the Aggressive Dynamic model with the Baseline Multi-Factor provides favourable assessments for the former for almost all metrics we report. The risk / reward of the
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Aggressive Dynamic model more than triples relative to the Baseline Multi-Factor, from 0.18 to 0.58. The hit ratio improves by about an absolute 10%, from 55.49% to 64.02%, which is more than 15% in relative terms. This improvement does not seem to come at a significant implementation cost as we can infer from the turnover statics we present in the bottom row of Table 3. [Figure 4 about here] To rule out the possibility that the results of our analysis are concentrated in certain periods that make up for poor performance in other periods, we carry out a sub-period analysis. We split the sample in two almost equal sub-samples, i.e. from January 1999 to December 2005 and from January 2006 to August 2012, and repeat the analysis. We report the results in Table 4. These results should be interpreted cautiously given the relative short time series they represent. The results indicate that the conclusions reached in the previous section for the whole period hold true in the sub-periods. We observe that all models perform better in the first sub-sample; however the relative ranking of the models remains intact in the second sub-period. In fact, in the second subperiod we observe that the economic benefits of the Aggressive Dynamic model are more pronounced; in fact it is the only model that produces positive average returns. [Table 4 about here] In additional analysis (available on request) we used a binomial distribution (and assumptions about its normality) to assess the statistical significance of the incremental value of the Aggressive Dynamic model over the Active Dynamic model, as well as over the Baseline MultiFactor model with respect to their hit rates. In the full sample, we concluded that the Aggressive Dynamic models incremental value over the Active Dynamic was marginally statistically significant at the 5% significance level (t-statistic=1.96). We also found that the Aggressive
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Dynamic models incremental value over the Baseline Multi-Factor was highly statistically significant (t-statistic=4.43). In the sub-samples the respective statistics are 1.00 and 3.66 for the first sub-period and 1.79 and 2.68 for the second sub-period. We also tested similar hypotheses with respect to the mean returns of the three strategies and obtained qualitatively similar results. Given the relatively small number of observations in the sample and the impact of this on the calculated statistics, we suggest interpreting the statistics with caution.

Conclusion
This article investigates recent episodes in financial markets and their impact on factor rotation decisions. Our investigation of the events reaches three main conclusions that are particularly important for factor rotation decisions. First, that factor portfolios can at times become crowded and this poses significant systemic risk. Second macroeconomic factors can become largely important drivers of factor portfolio returns which we characterize as another form of systemic risk given the global reach of these factors. Third, that factor/style rotations have been compressed into shorter periods of time. We integrate these observations in a new factor rotation model that is suitably tailored to accommodate episodes of this kind. Our model uses novel predictive variables that we are able to obtain through risk attribution analysis and a non-parametric statistical technique that is well behaved in modeling highly dynamic systems. The model we propose provides significant value when appliead in a single-factor setting. We demonstrate that the outperformance of the model is even more pronounced when it is used in a dynamice multi-factor setting. The results we produce are robust in the sub-periods we examined and in relative terms are better in the second half of our sample that inludes the Global Financial Crisis as well as other severe episodes in the financial markets.

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Appendix
The U.S. Equity Risk Attribute Model (RAM) is a macroeconomic time series type of risk model. It estimates volatility and tracking error of a portfolio relative to its benchmark. The model decomposes both individual security and portfolio risk into a systematic component common to all stocks as well as an unsystematic or stock-specific (idiosyncratic) component. The systematic component of risk is then further broken down into components attributable to each of the factors. The U.S. RAM Model uses eight macroeconomic factors and four equity market factors. The factor sensitivities, or betas, of an individual stock are estimated by regressing ten years of monthly stock total returns on the monthly values of the 12 factors. This RAM risk model can help investors estimate the risk of their portfolio, and identify where the risk is coming from. By doing so, investors can better understand the performance of the portfolio as how it varies with changes in the market and economy; such as wider credit spreads, falling interest rates, rising oil prices, a weak dollar and small-cap underperformance. Below, we provide definitions of the risk factors used in U.S. RAM Version 4.0: Macroeconomic Factors Economic growth shock. The economic growth factor is the difference of actual vs. consensus expectation of monthly change in industrial production, surprise in monthly industrial production. A positive beta to this factor implies that the portfolio is likely to benefit from positive surprise in economic growth reflected in industrial production. Inflation shock. The inflation shock factor is the difference of actual vs. consensus expectation of monthly change in CPI. A positive portfolio beta to this factor implies that the portfolio is likely to benefit from an increase in unexpected inflation.

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Long-term interest rates. The long-term interest rate factor is the monthly change of 10-year US treasury bond yields. A positive portfolio beta to this factor implies that the portfolio is likely to benefit from rising long-term interest rates. Short-term interest rates. The short-term interest rate factor is the monthly change of 3-month US treasury bill yields. A positive portfolio beta to this factor implies that the portfolio is likely to benefit from rising short-term interest rates. Credit spread. The credit factor is the monthly change of yield spreads between Citi High Yield index and 10-year U.S. government bond. A positive portfolio beta to this factor implies that the portfolio is likely to benefit from widening credit spread. Oil. The oil factor is the monthly percentage change of prices of WTI benchmark crude oil. A positive portfolio beta to this factor implies that the portfolio is likely to benefit from rising oil prices. Trade-weighted dollar. The U.S. dollar factor is the monthly percentage change of the Bank of England trade-weighted effective rate US dollar index. A positive portfolio beta to this factor implies that the portfolio is likely to benefit from stronger U.S. dollar. Illiquidity. The illiquidity factor is the monthly change of the equal-weighted average of illiquidity measure of Russell 1000 stocks, defined as the absolute value of return over dollar trading volume. A positive portfolio beta to this factor implies that the portfolio is likely to be more defensive against less liquidity in the equity market. Equity Market Factors Equity market performance is impacted by macroeconomic factors and the correlations between different segments of the market. Therefore, the U.S. RAM measures the U.S. market, small-cap

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premium, growth/value style premium, and sector factors after adjusting for the correlations with other factors. These adjusted factors are refered to as residualized factors. Market. The market factor is the monthly S&P 500 Index returns, residualized against all the macroeconomic factors listed above. A positive portfolio beta to this factor means that the portfolio is likely to benefit from rising U.S. equity market. Small-Cap Premium. The small-cap size factor is the monthly return spread of Russell 2000 index vs. S&P 500 Index, residualized against all the macroeconomic factors and the market factor listed above. A positive portfolio beta to this factor implies that the portfolio is likely to benefit from small-cap outperformance over large caps. Growth/Value Premium. The style premium factor is the monthly return spread of S&P 500 Large Cap Growth Index vs. Value Index, residualized against all the macroeconomic factors and the market, size premium factors listed above. A positive portfolio beta to this factor implies that the portfolio is likely to benefit from growth stock outperformance over value stocks. Sector. The sector factor is the monthly S&P 500 GICS sector index returns, residualized against all the macroeconomic factors and the market, size and style premium factors listed above. A positive portfolio beta to this factor implies that the portfolio is likely to benefit from rising sector performance. Figure 5 shows the capitalization-weighted R-squared for the period 2006 to 2012 (August) for the stocks in the S&P 1500. For every stock in the universe, we measured the variance of the returns explained by all 12 factors and only with eight macroeconomic factors as a percentage of the total variance of the returns. While the R-squared of all factors has been relatively stable, the

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R-squared of the eight macro factors continues to increase, from 18% in 2006 to 33% in the middle of 2012, contributing a higher percentage of RAMs explanatory power. [Figure 5 about here]

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Tables and Figures

Figure 1 Cross-sectional Correlation between Price Momentum and Short Interest Ratio
July 2007 January 2008

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Figure 2 Style total return risk decomposition and Macro loadings Panel A: Momentum

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Figure 2 (continued) Panel A: Earnings Revisions

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Figure 3 Decision Tree for Determining the Direction of the Information Coefficient Momentum Panel A: Momentum

Panel B: Earnings Revisions

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Figure 4 Historical Performance of Dynamic Factor Rotation Strategies

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Figure 5 U.S. RAM Explanatory Power (S&P 1500 Universe)

R-Squares by Factor Groups 70%

60%

50%

40% Market Factors 30% Macro Factors

20%

10%

0% 2006 2007 2008 2009 2010 2011 2012

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Table 1 Performance of quant factors, March 2009 to August 2012

March to December 2009 Momentum Earnings Revision Book Yield Earnings Yield -61.29 -39.18 59.80 -13.50 January to April 2010 6.87 -1.47 7.54 -9.49 May to August 2010 -3.43 -1.40 -4.01 6.85 September to December 2012 -2.69 -3.42 1.79 -4.10 January to September 2011 -2.18 3.40 -15.53 3.91 November to December 2011 3.75 1.55 -2.40 0.23 January to February 2012 -11.81 -5.03 3.96 1.05 March to June 2012 18.49 4.41 -5.64 -2.82

October 2011 -2.55 -3.83 5.57 -0.14

August 2012 -2.55 0.07 2.73 1.56

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Table 2 Descriptive statistics of Single Factor Timing Strategies

Baseline Active Aggressive Baseline Active Aggressive

Geometric Mean Return (annualized) Arithmetic Mean Return (annualized) p-value (H0: Arithmetic Mean0) Standard Deviation (annualized) Return / risk (annualized) p-value (H0: Mean Return /risk0) Hit ratio Average return when correct Average return when wrong Predicted switches H-M non-parametric test p-stat H-M parametric test t-stat Geometric Mean Return (annualized) Arithmetic Mean Return (annualized) p-value (H0: Arithmetic Mean0) Standard Deviation (annualized) Return / risk (annualized) p-value (H0: Mean Return /risk0) Hit ratio Average return when correct Average return when wrong Predicted switches H-M non-parametric test p-stat H-M parametric test t-stat

Panel A: Momentum -4.47 0.20 -0.08 4.05 0.50 0.29 28.12 26.44 0.00 0.15 0.00 0.00 57.93 59.15 2.73 2.67 -2.74 -2.33 NaN 16.00 NaN 1.05 NaN 2.62 Panel C: Book Yield 2.52 7.39 4.24 8.16 0.20 0.01 18.75 12.71 0.23 0.64 0.00 0.00 55.49 64.02 1.94 1.15 -1.59 -0.47 NaN 25.00 NaN 1.27 NaN 4.75

3.94 8.17 0.14 28.02 0.29 0.00 59.15 3.08 -2.39 16.00 1.05 2.62 10.41 12.07 0.01 18.46 0.66 0.00 64.02 2.27 -1.26 25.00 1.27 4.75

Panel B: Earnings Revision -3.34 1.80 6.25 -2.13 2.63 7.39 0.70 0.22 0.04 15.25 12.75 15.11 -0.14 0.21 0.49 1.00 0.00 0.00 54.88 61.59 61.59 1.35 1.21 1.75 -1.53 -0.99 -1.13 NaN 44.00 44.00 NaN 1.18 1.18 3.72 3.72 NaN Panel D: Earnings Yield 2.54 5.09 7.07 3.88 6.11 8.34 0.19 0.06 0.03 16.22 14.28 16.08 0.24 0.43 0.52 0.00 0.00 0.00 56.71 58.54 58.54 1.71 1.55 1.90 -1.39 -1.04 -1.20 NaN 12.00 12.00 NaN 1.08 1.08 NaN 5.06 5.06

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Table 3 Descriptive statistics of Multi-Factor Timing Strategies

Baseline Multi-Factor 1.49 3.03 0.26 17.26 0.18 0.00 55.49 3.23 -3.46 448.18 Active Dynamic 5.08 6.81 0.08 18.26 0.37 0.00 60.37 3.50 -3.90 474.14 Aggressive Dynamic 9.06 10.89 0.02 18.89 0.58 0.00 64.02 3.79 -4.21 524.74

Geometric Mean Return (annualized) Arithmetic Mean Return (annualized) p-value (H0: Arithmetic Mean0) Standard Deviation (annualized) Return / risk (annualized) p-value (H0: Return / risk 0) Hit ratio Average return when correct Average return when wrong Turnover

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Table 4 Multi-Factor Timing Strategies in Sub-Periods

Baseline Active Aggressive Multi-Factor Dynamic Dynamic JAN 1999 DEC 2005 8.41 13.04 15.19 10.29 15.16 17.66 0.08 0.03 0.02 19.39 20.34 21.87 0.53 0.75 0.81 0.00 0.00 0.00 60.71 67.86 70.24 4.07 4.15 4.42 -4.11 -4.83 -5.49 440.08 456.05 508.97 Baseline Active Aggressive Multi-Factor Dynamic Dynamic JAN 2006 AUG 2012 -5.72 -3.21 2.66 -4.60 -1.96 3.79 0.79 0.63 0.26 14.50 15.51 15.03 -0.32 -0.13 0.25 1.00 1.00 0.00 50.00 52.50 57.50 2.17 2.61 2.97 -2.93 -3.23 -3.27 456.58 492.90 541.09

Geometric Mean Return (annualized) Arithmetic Mean Return (annualized) p-value (H0: Arithmetic Mean0) Standard Deviation (annualized) Return / risk (annualized) p-value (H0: Return / risk 0) Hit ratio Average return when correct Average return when wrong Turnover

38