By Nick Kalivas, Senior Equity Product Strategist
The high beta, value and size factors outperformed the broad-market S&P 500 Index by a sizeable margin during the third quarter, with the S&P 500 High Beta Index gaining 12.18% during the three-month period - outpacing all other factor indexes. The S&P 500 Index rose a healthy 3.85%, but 14 smart beta strategies and two smaller-cap indices - the S&P SmallCap 600 Index and S&P MidCap 400 Index - all outperformed the broader market.1
There was a nearly 14.70% total return gap between the best-performing factor (high beta) and the poorest-performing factor (low volatility) during the third quarter. This dispersion was greater than the second quarter's performance gap, but less than that of the first quarter, which saw significant market volatility. Year to date, there has been an even wider performance chasm from top to bottom, with the NASDAQ Dividend Achievers 50 Index up 22.6% and the Russell Top 200 Pure Growth Index down 0.22%.1 This dispersion underscores the differentiated return streams of factor-based strategies.
Factor performance by quarter in 2016
Source: Bloomberg L.P., Sept. 30, 2016. Past performance is no guarantee of future results. Investments cannot be made directly into an index.
As you can see from the performance table above, some of the worst performers in the first quarter of the year turned out to be the best performers in the third quarter. Conversely, some of the best performers in the first quarter lagged in the third quarter. This is not unusual and again speaks to the diversification potential of factor-based strategies.
The leaders: High beta, value strategies deliver solid third quarter performance
During the third quarter, the high beta factor benefited from heavy exposure to financials and energy stocks and limited exposure to utilities and consumer staples.1 Value-based strategies, represented by the Russell 2000 Pure Value Index and the Russell Top 200 Pure Value Index, also had significant exposure to financials and energy stocks, which boosted their returns.1
High beta and value strategies were also buoyed by an improved economic backdrop. The ISM Manufacturing Index, considered a barometer of US industrial activity, jumped from 52.7 in May to 56.1 in June - its highest level since October 2015. Moreover, non-farm payrolls rose by more by than 270,000 in both June and July.1
Narrowing credit spreads hint at increased risk tolerance
The improved outlook for economic growth led to a drop in high yield credit spreads during the quarter. The BarCap U.S. Corporate High Yield-to-Worst 10-year Treasury spread fell from 5.81 to 4.58, while the US 10-year Treasury yield bottomed out at 1.32% on July 6.1 Volatility, in the form of the CBOE Volatility Index (VIX), eased during the third quarter, falling from 15.63 to 13.20.1 Although the economy appeared less vibrant in September, a bias toward higher interest rates, a downward slant in high yield spreads and benign volatility were all favorable for investor risk taking.
Macro factors may not completely explain the favorable impact of energy exposure on value stocks and high beta based indices; stock selection was also important to energy sector returns. The 12-month Bloomberg Nymex Crude Oil Strip 12-Month Strip Futures Price Index finished the quarter at $50.46 - down marginally from Q2, but still above $50 for the second consecutive quarter. The rebound in oil prices coincided with OPEC's decision to cut production in late September.1
Year to date, the NASDAQ Dividend Achievers Index has been the strongest performer - driven by energy and utilities and solid stock selection in financials, staples and industrials. The combination of dividend growth and yield was positive during the first half of 2016, and led to only slight underperformance in the third quarter.
What's behind the performance of high beta stocks?
The strong quarterly performance of high beta stocks makes sense when you consider that high beta can outpace low volatility during periods of rising 10-year Treasury yields and stronger economic growth, when investor demand for defensive stocks may ease. The charts below depict this relationship.
Source: Bloomberg L.P., Sept. 30, 2016. Investments cannot be made directly into an index.
Source: Bloomberg L.P., Sept. 30, 2016. Investments cannot be made directly into an index.
The laggards: Low volatility struggles amid increased investor appetite for risk
The S&P 500 Low Volatility Index struggled during the third quarter after posting solid gains in the first half of 2016. The index was pressured by exposure to utilities and staples, and an environment that encouraged investor risk taking. During this time, the S&P 500 Utility Index fell 6.72%, and the S&P 500 Consumer Staples Index declined 3.27%.1 Smaller-cap shares within the quality and momentum spaces also lagged. Because low volatility tends to be a defensive strategy, its performance in a "risk-on" (risk tolerant) environment was to be expected. But mid- and large-cap momentum's underperformance was surprising, in my view. Poor selection and allocation to the information technology, consumer staples and real estate sectors appear to have contributed to this underperformance.
Looking ahead: Signs of an economic rebound, but risks remain
Although investors expect to be rewarded for their factor exposure over long time horizons, shifting market conditions can lead to choppiness over the near term. Looking ahead, the value and size factors could benefit from the indicators of economic firming, including reduced inventory overhang, increased industrial production, a sideways-trading US dollar, a trough in the earnings cycle and rising commodity prices. Both the value and size factors tend to shine during periods of accelerating economic growth and rising interest rates.
Overseas, there are signs of reflation in the global economy. Nonetheless, uncertainty over the fallout from Brexit and eurozone disintegration, concerns about Asian and European banks and the ramifications of November's US elections are all complications that could support market volatility for the duration of the year.
Given this uncertainty, defensive factors like low volatility and quality may help mitigate risk and provide potential diversification benefits. Investors expecting stronger growth, but concerned about lingering risks, may wish to explore blending value and low volatility strategies or quality and high beta strategies.
1 Bloomberg L.P., Sept. 30, 2016
Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time. There is no guarantee that low-volatility stocks will provide low volatility.
A basis point is a unit that is equal to one one-hundredth of a percent.
Factor-based strategies make use of rewarded risk factors in an attempt to outperform market-cap-weighted indexes, reduce portfolio risk, or both.
Spread represents the difference between the yield on a corporate bond and a similar maturity US Treasury bond.
Dividends/high dividend shows how much a company pays out each year to shareholders relative to its share price. Companies characterized as high dividend tend to issue higher annual payouts. Securities that pay high dividends as a group can fall out of favor with the market, causing such companies to underperform companies that do not pay high dividends.
Dividend growers rank securities by their dividend yield while seeking to increase overall portfolio yield and potential for improved price performance.
Low volatility utilizes volatility rankings while seeking to minimize the effects of market fluctuations.
Momentum ranks securities relative to peers, utilizing relative strength methodology to identify the strongest and weakest investment trends. The momentum style of investing is subject to the risk that the securities may be more volatile than the market as a whole, or that the returns on securities that have previously exhibited price momentum are less than returns on other styles of investing.
Quality/high quality is a ranking that reflects the long-term growth and stability of a company's earnings and dividends. It focuses on companies that have a Standard & Poor's quality ranking of A- or above that have historically exhibited higher Sharpe ratios and lower volatility.
High beta utilizes a beta-weighted methodology to increase exposure to market movements of a benchmark without incorporating leverage. (Beta is a measure of risk representing how a security is expected to respond to general market movements.) Beta investing entails investing in securities that are more volatile based on historical market index data.
Buyback tracks US companies that consistently repurchase their own outstanding shares used by institutions and active managers for decades. Common stock risk is the financial risk that the value of an individual company's stock may fall as a result of factors directly relating to that company, such as decisions made by its management or lower demand for the company's products or services. Common stocks may decline significantly in price over short or extended periods of time.
Fundamentals weighted ranks all publicly listed US companies according to four fundamental measures of company size: sales, cash flow, book value and dividends.
The BarCap U.S. Corporate High Yield-to-Worst 10-year Treasury spread is calculated by taking the BarCap U.S. Corporate High Yield-to-Worst Index minus the US 10-year Treasury yield.
The Bloomberg NYMEX Crude Oil Strip 12-Month Strip Futures Price Index represents the average price of the first 12 monthly NYMEX crude oil futures contracts using Bloomberg fair value prices.
The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. VIX is the ticker symbol for the Chicago Board Options Exchange (NASDAQ:CBOE) Volatility Index, which shows the market's expectation of 30-day volatility.
The Dorsey Wright Sector 4 Index selects up to four exchange-traded funds from the PowerShares DWA Momentum Sector lineup of ETFs with the objective of gaining exposure to the strongest relative strength sectors in the US equity space on a monthly basis.
The ISM Manufacturing Index, which is based on Institute of Supply Management surveys of more than 300 manufacturing firms, monitors employment, production inventories, new orders and supplier deliveries.
The S&P 500 Low Volatility High Dividend Index is composed of 50 securities traded on the S&P 500 Index that historically have provided high dividend yields and low volatility.
The NASDAQ US Dividend AchieversTM 50 Index is composed of 50 stocks selected principally on the basis of dividend yield and consistent growth in dividends.
The Russell Top 200® Pure Growth Index is composed of securities with strong growth characteristics selected from the Russell Top 200® Index. Securities are weighted based on their style score.
The Russell Top 200® Pure Value Index is composed of securities with strong value characteristics selected from the Russell Top 200® Index. Securities are weighted based on their style score.
The Russell 1000® Equal Weight Index captures the risk and return performance of an equal weight investment strategy for US large-cap stocks. The Russell 1000® Equal Weight Index is a trademark/service mark of the Frank Russell Co.
The Russell 2000® Pure Growth Index is composed of securities with strong growth characteristics selected from the Russell 2000® Index. Securities are weighted based on their style score.
The Russell 2000® Pure Value Index is composed of securities with strong value characteristics selected from the Russell 2000® Index. Securities are weighted based on their style score.
The Russell Midcap® Pure Growth Index is composed of securities with strong growth characteristics selected from the Russell Midcap® Index. Securities are weighted based on their style score.
The Russell Midcap® Pure Value Index is composed of securities with strong value characteristics selected from the Russell Midcap® Index. Securities are weighted based on their style score.
The S&P MidCap 400 Low Volatility Index consists of 80 out of 400 medium-capitalization range securities from the S&P MidCap 400 Index with the lowest realized volatility over the past 12 months.
The S&P 500® Low Volatility Index consists of the 100 stocks from the S&P 500® Index with the lowest realized volatility over the past 12 months.
The S&P 500® High Quality Rankings Index is designed to provide exposure to the constituents of the S&P 500 Index that are identified as stocks reflecting long-term growth and stability of a company's earnings and dividends.
The Dynamic Large Cap Growth IntellidexSM Index seeks to provide capital appreciation while maintaining consistent stylistically accurate exposure. The Style Intellidexes apply a rigorous 10-factor style isolation process to objectively segregate companies into their appropriate investment style and size universe.
The S&P 500® Index is an unmanaged index considered representative of the US stock market.
The NASDAQ US BuyBack Achievers™ Index is designed to track the performance of companies that meet the requirements to be classified as BuyBack Achievers™. The NASDAQ US BuyBack Achievers Index is composed of US securities issued by corporations that have effected a net reduction in shares outstanding of 5% or more in the trailing 12 months.
The S&P 500® High Beta Index consists of the 100 stocks from the S&P 500® Index with the highest sensitivity to market movements, or beta, over the past 12 months. Beta is a measure of relative risk and is the rate of change of a security's price.
The S&P 500 Enhanced Value Index is designed to measure the performance of the top 100 stocks in the S&P 500 Index with attractive valuations based on "value scores" calculated using three fundamental measures: book value-to-price, earnings-to-price and sales-to-price.
The Dynamic Large Cap Value IntellidexSM Index is designed to provide capital appreciation while maintaining consistent stylistically accurate exposure. The Style Intellidexes apply a rigorous 10-factor style isolation process to objectively segregate companies into their appropriate investment style and size universe.
The Dorsey Wright Technical LeadersTM Index includes approximately 100 US companies from a broad mid- and large-capitalization universe. The index is constructed pursuant to Dorsey, Wright & Associates, LLC's proprietary methodology, which takes into account, among other factors, the performance of each of the approximately 1,000 largest companies in the eligible universe as compared to a benchmark index, and the relative performance of industry sectors and sub-sectors.
The FTSE RAFI US 1000 Index is designed to track the performance of the largest US equities, selected based on the following four fundamental measures of firm size: book value, cash flow, sales and dividends. The 1,000 equities with the highest fundamental strength are weighted by their fundamental scores.
The S&P SmallCap 600 Low Volatility Index consists of 120 out of 600 small-capitalization range securities from the S&P SmallCap 600® Index with the lowest realized volatility over the past 12 months.
The S&P MidCap 400 Index is an unmanaged index considered representative of mid-sized US companies.
The Dynamic Market IntellidexSM Index seeks to identify and select companies from the US marketplace with superior risk-return profiles.
The S&P 500® Dynamic VEQTOR Index provides investors with broad equity market exposure with an implied volatility hedge by dynamically allocating between equity, volatility and cash. The index allows investors to receive exposure to the equity and volatility of the S&P 500 Index in a dynamic framework.
The S&P SmallCap 600® Index is a market-value-weighted index that consists of 600 small-cap US stocks chosen for market size, liquidity and industry group representation.
The FTSE RAFI US 1500 Small-Mid Index is designed to track the performance of small and medium-sized US companies. Companies are selected based on the following four fundamental measures of size: book value, cash flow, sales and dividends. Each of the equities with a fundamental weight ranking of 1,001 to 2,500 is then selected and assigned a weight equal to its fundamental weight.
The Dorsey Wright SmallCap Technical Leaders™ Index includes securities pursuant to a Dorsey, Wright & Associates, LLC proprietary selection methodology that is designed to identify companies that demonstrate powerful relative strength characteristics. Approximately 200 companies are selected for inclusion from a small-cap universe of approximately 2,000 of the smallest US companies selected from a broader set of 3,000 companies.
Diversification does not guarantee profit or eliminate the risk of loss.
Many products and services offered in technology-related industries are subject to rapid obsolescence, which may lower the value of the issuers.
Investments in real-estate-related instruments may be affected by economic, legal or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small- and mid-cap companies, and their shares may be more volatile and less liquid.
The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
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