The power of factor investing was displayed brightly during the second quarter, as 18 single-factor and multi-factor indexes in the chart below outperformed the market-cap-weighted S&P 500 Index. Dividend and low volatility strategies were among the top performers, but mid-cap value and momentum posted a solid showing. In contrast, buyback, large-cap value and large-cap growth lagged.
The spread between the best-performing factor index, the NASDAQ US Dividend Achievers 50 Index, and the worst-performing factor index, the NASDAQ US Buyback Achievers Index, was 9.70% in the second quarter. This return dispersion among factors was much less than the dispersion seen over the first half of 2016, which was more than twice as large at 24.56%. The NASDAQ Dividend Achievers 50 Index was not only the best performer in the second quarter, but also for the first half of 2016 (+18.83%). The Dorsey Wright Small Cap Technical Leaders Index was the biggest laggard (-5.73%) in the first half of 2016.1
Select factor performance sorted by Q2 returns
Source: Bloomberg LP, as of June 30, 2016. Q2 performance is April 1, 2016, through June 30, 2016. H1 performance is Jan. 1, 2016, through June 30, 2016. Past performance is not a guarantee of future results.
In the short term, factor performance can be influenced by market conditions. Here are some of the macro trends that influenced factor performance during the second quarter:
- Sovereign yields fell sharply as investors were disappointed over the pace of global economic growth, concerned about the health of European banks, and positioned for the risks of Brexit. These dynamics were complemented by the European Central Bank's (ECB's) quantitative easing program. During the second quarter, the US 10-year Treasury lost about 30 basis points (bps), finishing just below 1.47%, while the 10-year sovereign yield in Germany turned negative and dropped about 28 bps, finishing the second quarter at -13 bps.1 Rounding out the major markets, the Japanese 10-year yield declined about 19 bps, falling to -22 bps.1 Negative to low nominal 10-year yields and core inflation rates above 10-year yields in Germany, Japan and the US drove investors toward dividend-paying stocks. Not only do dividend payers offer competitive yields to sovereign debt, but companies have the ability to raise dividends and provide inflation-hedging potential to investors.
- Although not a primary characteristic, one of the typical attributes of low volatility stocks is a dividend payment. Therefore, the low volatility factor benefited from investors seeking yield as well as the spike in volatility around the Brexit vote. Maybe more important, the CBOE Volatility Index (VIX) rose sharply on June 10 and spiked to over 25 on June 24 and 25 before easing later in the month after Brexit.1 The low volatility factor may show excess return during periods of high or rising equity market volatility, and it remained a go-to option during this period of unease over economic growth and political risks.
- Mid-cap value's performance was lifted by its overweight to real estate, energy and utilities. Real estate investment trusts (REITs) and utilities were supported by the drop in interest rates, while oil prices rallied in the second quarter with front-month West Texas Intermediate crude oil futures increasing from $38.34 to $48.33 to the benefit of mid-cap energy shares.1
- Like mid-cap value, the Dorsey Wright Sector 4 Total Return Index, which uses momentum for sector and stock selection, profited from its allocation and selection in materials and utilities relative to the S&P 500 Index. It was able to capture the benefits of falling rates and recovery in commodity prices, which improved the pricing power of firms operating in the materials sector. Raw material prices, as defined by the Commodity Research Bureau BLS/US Spot Raw Industrials Index, rose 2.5% during the second quarter.1
- The buyback factor lagged. Lack of exposure to energy (few companies were buying back shares after the oil crash) and disappointing results at traditional retailers were dynamics that pressured the strategy.
- Buyback is also a derivative of a value strategy, and large-cap value struggled during the first half. In particular, the S&P 500 Enhanced Value Index was pressured by its exposure to refiners (which were on the wrong side of the quarter's oil rally), brick-and-mortar retail and autos.
- The growth factor was hurt by its lack of exposure to utilities, REITs, energy and materials. The falling-rate environment and recovery in commodity prices was a drag.
- Small-cap momentum also struggled due to lack of exposure to utilities and energy, and its allocation to consumer discretionary.
What can we say about the environment going forward?
- Looking to the third quarter, investors face uncertainty over the impact of Brexit on global growth and the makeup of the European Union and European Monetary Union. Moreover, the US presidential election will heat up. These uncertainties are likely to spotlight risk mitigation strategies like low volatility, in my view. In contrast, momentum may be hurt by a "risk-on/risk-off" environment where investors are more concerned about adding or reducing exposure in reaction to political risks than focusing on company fundamentals.
- Beyond the impact of politics, Bank of England (BOE) Governor Mark Carney suggested the BOE would likely cut interest rates this summer, and the ECB suggested it is looking into loosening the rules around its bond purchases program due to a shortage of bonds related to Brexit. The ECB's comments indicate a strong demand for high-quality debt. This reinforces the idea that investors will be hunting for yield, and this dynamic is likely to support dividend-paying stocks, in my view. The dividend yield on the S&P 500 Index was 2.17% as of June 30 and comfortably above the 10-year Treasury yield near 1.50%.1Until there is a meaningful shift in the rate environment, I believe dividend and low volatility stocks are likely to remain a focus. Value stocks, in contrast, face a headwind in a low-rate environment due to their need for vibrant economic growth in order to outperform.
- The economy is showing some signs of improvement but has yet to display breakout growth. The June Manufacturing PMI rose 1.9 to 53.2, in line with slow expansion.1 The headwind of inventory overhang is slowly abating, while the more two-way trade of the dollar over the last year has taken some pressure off of the export sector. Housing appears to be experiencing a slow-steady recovery, while unemployment claims remain low, below 300,000.1 There is enough growth to push profits forward, but at this point it's not enough to overcome the deflation fears in Japan and Europe. The value factor would be more likely to generate excess returns in a vibrant economic environment where interest rates are increasing. In my view, quality stocks may strike a nice balance of being able to deliver profits in an environment of slow growth with the opportunity to participate in accelerating economic activity if it develops.
Investors looking for low volatility and dividend solutions may want to consider PowerShares low volatility solutions, including the PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA:SPLV), PowerShares S&P MidCap Low Volatility Portfolio (NYSEARCA:XMLV), PowerShares S&P SmallCap Low Volatility Portfolio (NYSEARCA:XSLV) and PowerShares S&P 500 High Dividend Low Volatility Portfolio (NYSEARCA:SPHD).
1 Source: Bloomberg LP, as of June 30, 2016
Past performance is no guarantee of future results.
A basis point is one hundredth of a percentage point.
Buyback tracks US companies that consistently repurchase their own outstanding shares of common stocks.
Dividend growth ranks securities by their dividend yield while seeking to increase overall portfolio yield and potential for improved price performance.
Equal weighted gives each security an equal weight within a portfolio.
Excess return refers to excess return generated by one index, strategy or investment factor over another.
Fundamentals weighted ranks all publicly listed US companies according to four fundamental measures of company size: sales, cash flow, book value and dividends.
High beta uses 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.
Low volatility describes using volatility rankings while seeking to minimize the effects of market fluctuations. Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time. Of course, low volatility cannot be guaranteed.
Momentum ranks securities relative to peers, utilizing relative strength methodology to identify the strongest and weakest investment trends. Momentum 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 ranks the long-term growth and stability of a company's earnings and dividends. 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.
Sector rotation refers to the nine broad economic sectors and cash ranked by relative strength (performance). The strongest four sectors (or cash) are chosen for inclusion in the strategy. The process is evaluated monthly for changes.
Spread represents the difference between two values.
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 Commodity Research Bureau BLS/US Spot Raw Industrials Index represents the price movement of a basket of commodities believed to be influenced by changes in economic conditions.
The Dorsey Wright® Sector 4 Total Return Index is designed to gain exposure to the strongest relative strength sectors in the US through the universe of nine PowerShares DWA sector momentum ETFs.
The Dorsey Wright SmallCap Technical LeadersTM 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.
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 a Dorsey, Wright & Associates, LLC, 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 subsectors.
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 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 Dynamic Market IntellidexSM Index seeks to identify and select companies from the US marketplace with superior risk-return profiles.
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 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 NASDAQ US BuyBack AchieversTM 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 NASDAQ US Dividend Achievers 50 IndexTM comprises 50 stocks selected principally on the basis of dividend yield and consistent growth in dividends.
PMI (formerly Purchasing Managers Index), a commonly cited indicator of the manufacturing sectors' economic health, is calculated by the Institute of Supply Management.
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 500® Enhanced Value Index is designed to measure the performance of the top 100 stocks in the S&P 500® with attractive valuations based on "value scores" calculated using three fundamental measures: book value-to-price, earnings-to-price and sales-to-price ratios.
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® 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 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 Momentum Index tracks the performance of stocks in the S&P 500® Index that have a high "momentum score."
The S&P 500® Quality Index tracks the performance of stocks in the S&P 500® Index that have the highest quality score, which is calculated based on three fundamental measures: return on equity, accruals ratio and financial leverage ratio.
The S&P MidCap 400 Index is an unmanaged index considered representative of mid-sized US companies.
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 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 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.
Factor investing is an investment strategy in which securities are chosen based on attributes that have been associated with higher returns.
Commodities, currencies and futures generally are volatile and are not suitable for all investors.
The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
The performance of an investment concentrated in issuers of a certain region or country is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified investments.
Investments focused in a particular industry, such as real estate, are subject to greater risk and are more greatly impacted by market volatility than more diversified investments.
Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.
Investing in securities of large-cap companies may involve less risk than is customarily associated with investing in stocks of smaller companies.
Issuers of sovereign debt or the governmental authorities that control repayment may be unable or unwilling to repay principal or interest when due, and the fund may have limited recourse in the event of default. Without debt holder approval, some governmental debtors may be able to reschedule or restructure their debt payments or declare moratoria on payments.
Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer's credit rating.
A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.
There are risks involved with investing in ETFs, including possible loss of money. Index-based ETFs are not actively managed. Actively managed ETFs do not necessarily seek to replicate the performance of a specified index. Both index-based and actively managed ETFs are subject to risks similar to stocks, including those related to short selling and margin maintenance. Ordinary brokerage commissions apply. The fund's return may not match the return of the index. The funds are subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the funds.
Shares are not individually redeemable, and owners of the shares may acquire those shares from the fund and tender those shares for redemption to the fund in creation unit aggregations only, typically consisting of 50,000, 75,000, 100,000 or 200,000 shares.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: This article was posted on the Invesco PowerShares' blog by an Invesco PowerShares' employee on July 11,2016: https://www.blog.invesco.us.com/factor-performance-dividends-low-volatility