How AI May Help Investors Tackle Cyclicality of Equity Factors

AI-driven dynamic factor timing may help investors adjust to the natural cycles of factor performance, potentially enhancing responsiveness to changing market conditions.

KEY POINTS

What it is

We explore how an artificial intelligence-based framework could improve equity-factor performance by dynamically adjusting to market conditions over time.

Why it matters

Traditional, static methods may not pick up these market changes, while artificial intelligence approaches are well-suited to identify them and adjust.

Where it's going

We anticipate several important implications of this methodology, providing investors with enhanced tools for navigating increasingly complex financial markets.

Equity investors have long embraced equity factor-based investing — using factors such as quality, value and momentum — with the aim of improving portfolio performance. However, just like many other assets, factors exhibit cyclicality, meaning they can each go through periods of underperformance. In recent research, we collaborated with University of Chicago Professor Stefan Nagel to uncover ways to apply artificial intelligence to potentially mitigate the risks of cyclicality through what we call dynamic factor timing. Let’s take a closer look.

Factor timing involves identifying relationships between variables such as sentiment, valuation, or the business cycle and how they impact factor returns. Most prevailing factor timing techniques are static in nature, following the model output to overweight the factors more likely to outperform. However, this static approach ignores the changing, or dynamic, relationship between predictor variables and factor performance over time. Recognizing that, in reality, factor relationships are not constant, we aimed in our research to build upon static approaches and create a dynamic approach to capture changing relationships. We call this dynamic factor timing.

With dynamic factor timing, we used artificial intelligence to determine whether the output from a factor timing approach has a sufficient chance of success. In other words, artificial intelligence can insert skepticism into the mix of whether to apply a factoring timing approach and to what degree. Should the approach deem factor timing temporarily ineffective, then the use of factor timing could be dialed down, or even turned off. This can happen when the degree of skepticism is high, as determined by artificial intelligence. Alternatively, when the model is confident and the degree of skepticism is low, the portfolio tilts toward the dynamic factor-timing portfolio.

We have found through this research with Professor Nagel that merely identifying and exploiting relationships that are economically meaningful and showing positive long-run average results can ignore how those relationships change over time. Traditional, static methods may not pick up these changes, while artificial intelligence approaches are well-suited to identify them and adjust. We anticipate several important implications of this research, providing investors with enhanced tools for navigating increasingly complex financial markets.

Meet Your Expert

Michael Hunstad, Ph.D.

Deputy Chief Investment Officer & Chief Investment Officer of Global Equities

Michael Hunstad is Deputy Chief Investment Officer and Chief Investment Officer of Global Equities for Northern Trust Asset Management. Michael is a member of the Asset Management Executive Group and has oversight of all equity portfolio management, research and trading activities including quantitative, index and tax-advantaged strategies. Additionally, he assists with the development of investment vision, strategy portfolio construction and risk management framework for the firm’s broad investment platform.

Read Bio

IMPORTANT INFORMATION

Northern Trust Asset Management (NTAM) is composed of Northern Trust Investments, Inc., Northern Trust Global Investments Limited, Northern Trust Fund Managers (Ireland) Limited, Northern Trust Global Investments Japan, K.K., NT Global Advisors, Inc., 50 South Capital Advisors, LLC, Northern Trust Asset Management Australia Pty Ltd, and investment personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.

Issued in the United Kingdom by Northern Trust Global Investments Limited, issued in the European Economic Association (“EEA”) by Northern Trust Fund Managers (Ireland) Limited, issued in Australia by Northern Trust Asset Management (Australia) Limited (ACN 648 476 019) which holds an Australian Financial Services Licence (License Number: 529895) and is regulated by the Australian Securities and Investments Commission (ASIC), and issued in Hong Kong by The Northern Trust Company of Hong Kong Limited which is regulated by the Hong Kong Securities and Futures Commission.

For Asia-Pacific (APAC) and Europe, Middle East and Africa (EMEA) markets, this information is directed to institutional, professional and wholesale clients or investors only and should not be relied upon by retail clients or investors. This information may not be edited, altered, revised, paraphrased, or otherwise modified without the prior written permission of NTAM. The information is not intended for distribution or use by any person in any jurisdiction where such distribution would be contrary to local law or regulation. NTAM may have positions in and may effect transactions in the markets, contracts and related investments different than described in this information. This information is obtained from sources believed to be reliable, its accuracy and completeness are not guaranteed, and is subject to change. Information does not constitute a recommendation of any investment strategy, is not intended as investment advice and does not take into account all the circumstances of each investor.

This report is provided for informational purposes only and is not intended to be, and should not be construed as, an offer, solicitation or recommendation with respect to any transaction and should not be treated as legal advice, investment advice or tax advice. Recipients should not rely upon this information as a substitute for obtaining specific legal or tax advice from their own professional legal or tax advisors. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. Indices and trademarks are the property of their respective owners. Information is subject to change based on market or other conditions.

All securities investing and trading activities risk the loss of capital. Each portfolio is subject to substantial risks including market risks, strategy risks, advisor risk, and risks with respect to its investment in other structures. There can be no assurance that any portfolio investment objectives will be achieved, or that any investment will achieve profits or avoid incurring substantial losses. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Risk controls and models do not promise any level of performance or guarantee against loss of principal. Any discussion of risk management is intended to describe NTAM’s efforts to monitor and manage risk but does not imply low risk.

Past performance is not a guarantee of future results. Performance returns and the principal value of an investment will fluctuate. Performance returns contained herein are subject to revision by NTAM. Comparative indices shown are provided as an indication of the performance of a particular segment of the capital markets and/or alternative strategies in general. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index. Net performance returns are reduced by investment management fees and other expenses relating to the management of the account. Gross performance returns contained herein include reinvestment of dividends and other earnings, transaction costs, and all fees and expenses other than investment management fees, unless indicated otherwise. For U.S. NTI prospects or clients, please refer to Part 2a of the Form ADV or consult an NTI representative for additional information on fees.

Forward-looking statements and assumptions are NTAM’s current estimates or expectations of future events or future results based upon proprietary research and should not be construed as an estimate or promise of results that a portfolio may achieve. Actual results could differ materially from the results indicated by this information.

Not FDIC insured | May lose value | No bank guarantee