Dynamic Factor Rotation Strategy: A Business Cycle Approach

Abstract

This study developed an investment framework to implement dynamic factor rotation strategies according to changes in economic conditions. I constructed a useful macro indicator that tracked real-time business cycles of the US economy and applied a trend-filtering method to the indicator to identify economic regimes based on the level and momentum change. I found that historical performance of individual equity factors greatly differed across economic regimes, and this heterogeneity can be exploited to build dynamic factor rotation strategies by shifting exposures toward effective factors according to the different regimes. The out-of-sample analysis showed that the regime-based dynamic approach outperformed the static benchmark in terms of absolute and risk-adjusted returns after accounting for transaction costs. The results have important implications for many pension funds and for institutional investors interested in factor investing and seeking to improve the long-term portfolio performance.