The breadth of factor performance narrowed significantly in the first quarter of 2017. During this time, only four factor-based indices outperformed the broad-market S&P 500 Index, compared with 17 in the previous quarter. The large- and mid-cap growth and momentum factors were the clear winners during the first quarter, outperforming the S&P 500 Index by sizeable margins.
Headwinds following November's elections
Many factors faced headwinds following a strong post-election equity rally, with market gains highly concentrated. In fact, nearly a quarter of S&P 500 Index gains during the first quarter came from just three technology stocks. Performance concentration appears to have benefited the broader equity market, as well as large market-cap-weighted indexes as a whole.
Factor performance: Q1 2017, Q4 2016, post-election through Q1 2017
Source: Bloomberg L.P., March 31, 2017. Past performance is no guarantee of future results. Investments cannot be made directly into an index.
Low volatility macro environment
During the first quarter, the US economy continued to expand, with the ISM Manufacturing Index up nearly 5% and industrial commodities doing well, as measured by the CRB BLS Spot Index, which gained 4.4%. Market conditions were generally benign. 10-year US Treasury yields eased five basis points, while market volatility declined 11.9%, as measured by the CBOE Volatility Index (VIX). High yield spreads, as defined by the Barcap US Corporate High Yield to Worst―10-Year Treasury Spread Index, narrowed 23 basis points and finished the quarter at a modest 3.45%, indicating increased demand for riskier fixed income assets.
|Drivers of return||Q4 2016||Q1 2017||Difference||Pct. change|
|CBOE Volatility Index||14.04||12.37||-1.67||-11.89%|
|10-year Treasury yield||2.44%||2.39%||-0.05%||-2.05%|
|High yield spread||3.68%||3.45%||-0.23%||-6.25%|
|CRB BLS Spot Index||493.21||514.96||21.75||4.41%|
|US Dollar Index||102.21||100.35||-1.86||-1.82%|
|ISM Manufacturing Index||54.5||57.2||2.70||4.95%|
Source: Bloomberg L.P., March 31, 2017. Commodity prices defined by the CRB BLS Spot Index, high yield spread defined by the Barcap US Corporate High Yield to Worst―10-Year Treasury Spread Index. Past performance is no guarantee of future results. Investments cannot be made directly into an index.
Benign market conditions create headwinds to low volatility and quality
Narrowing credit spreads and reduced market volatility, coupled with a robust rally in the S&P 500 Index, created headwinds to the low volatility and quality factors during the first quarter. This comes as no surprise, as both of these strategies have the potential to do well in stressed market conditions. The S&P 500 Quality Index, with its underweight position in health care, financials, REITs and utilities, may have been less affected by the crosscurrents of politics and the debate over longer-term interest rates. Nonetheless, the quality benchmark underperformed the S&P 500 Index by 52 basis points.
Value and small caps fail to build on Q4 gains
Despite continued economic growth and rising commodity prices, the small-cap size and value factors lagged the S&P 500 Index in the first quarter. In fact, small-cap value was the single worst-performing factor in the first quarter of 2017, and was one of three benchmark small-cap indices that sustained negative returns.
The large-cap value factor, as gauged by the S&P 500 Enhanced Value Index, lagged the S&P 500 Index by 3.08%, owing primarily to its underweight position in information technology, overweight position in financials and poor selection in consumer discretionary stocks. The small- and mid-cap size factor, with the FTSE RAFI US 1500 Small-Mid Index as a proxy, underperformed the S&P 500 Index by nearly 5% - most noticeably due to its underweight position in information technology and poor selection in financials, consumer discretionary stocks and energy shares.
Outperformers: Growth and momentum factors gain
Conversely, the growth and momentum factors rebounded from a poor performance in the fourth quarter of 2016. The Russell Top 200 Pure Growth Index benefited from limited exposure to energy and financials, as well as its holdings in well-performing consumer discretionary stocks.
Mid- and large-cap momentum, as defined by the Dorsey Wright Technical Leaders Index, outperformed the S&P 500 Index by more than 2% in the first quarter of 2017, benefiting primarily from its selection in financials and limited exposure to energy shares. Momentum stocks underperformed last quarter, but experienced some mean reversion over the past few months. Why? The macro backdrop of continued economic growth and limited volatility may have created a favorable environment for momentum stocks by allowing investors to focus on company fundamentals and longer-term trends. Momentum stocks also benefited from low correlation among stocks. (Low stock correlation is often a sign that equity investors are focused more on individual company fundamentals than market conditions. This scenario typically benefits the momentum factor, which needs dispersion in returns and stable market leadership for success.)
The US economy appears to be in the process of a cyclical upswing, which could benefit smaller companies and the value factor. The following chart shows near-term trends in S&P 500 Index earnings per share. As you can see, earnings per share bottomed in the fourth quarter of 2015 and, according to consensus analyst estimates gathered by Standard & Poor's, large-company earnings are expected to exceed the recent cycle peak established in the second quarter before moving higher into 2018.
Source: Standard & Poor's, as of March 31, 2017
Although corporate profits are expected to rise, political uncertainty over the outlook for fiscal policy, coupled with the slow maturation of the profit cycle, underscores the need for risk mitigation, in my view. Although market volatility remains relatively low, a subsequent spike in volatility, coupled with weaker stock prices, could provide a case for risk management. For these reasons, I believe blending low volatility with value, or blending small cap with small-cap low volatility, may make for a sensible investment strategy over the coming months.
Investors interested in factor-based strategies may wish to explore PowerShares by Invesco's broad suite of ETFs.
Blog header image: Zurbagan/Shutterstock.com
Factor investing is an investment strategy in which securities are chosen based on certain characteristics and attributes.
Commodities and futures generally are volatile and are not suitable for all investors.
There is no guarantee that low-volatility stocks will provide low volatility.
Investing in securities of large-cap companies may involve less risk than is customarily associated with investing in stocks of smaller companies.
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.
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 the returns on other styles of investing.
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.
Treasury securities are backed by the full faith and credit of the US government as to the timely payment of principal and interest.
Debt securities are affected by changing interest rates and changes in their effective maturities and credit quality. Junk bonds involve a greater risk of default or price changes due to changes in the issuer's credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.
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.
Investments focused in a particular industry or sector are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.
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 10,000, 50,000, 75,000, 100,000 or 200,000 shares.
A basis point is a unit that is equal to one one-hundredth of a percent.
Correlation is the degree to which two investments have historically moved in relation to each other.
Earnings per share refers to a company's total earnings divided by the number of outstanding shares.
Spread represents the difference between the yield on a corporate bond and a similar maturity US Treasury bond.
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.
The Barcap US Corporate High Yield to Worst―10-Year Treasury Spread Index, which displays the yield spread between a portfolio of high yield notes as defined by Barclays Capital and the 10-year Treasury yield, measures risk in the high yield market.
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 CRB BLS Spot Index measures price movements of 22 sensitive basic commodities from markets presumed to be among the first to be influenced by changes in economic conditions.
The Dorsey Wright Sector 4 Total Return 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 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.
The Dorsey Wright Technical Leaders 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 Dynamic Large Cap Growth Intellidex 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 Intellidex 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 Intellidex 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 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 NASDAQ US BuyBack Achievers Index is designed to track the performance of companies that meet the requirements to be classified as BuyBack Achievers. It 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 Index is composed of 50 stocks selected principally on the basis of dividend yield and consistent growth in dividends.
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 Low Beta Equal Weight Index tracks US large-cap stocks that exhibit low beta, with all index constituents weighted equally within the index.
The Russell 2000 Index, a trademark/service mark of the Frank Russell Co., is an unmanaged index considered representative of small-cap stocks.
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 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 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 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 Index is an unmanaged index considered representative of the US stock market.
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 Low Volatility Rate Response Index is designed to measure the performance of the top 100 companies of the S&P 500 Index that have exhibited low volatility and are less sensitive to changes in interest rates.
The S&P 500 Momentum Index is designed to measure the performance of securities in the S&P 500 Index universe that exhibit persistence in their relative performance.
The S&P 500 Quality Index screens holdings based on three fundamental measures of quality - profitability, earnings quality and financial robustness - which help to assess a company's potential future profitability, as well as the financial risk each company faces.
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 High Dividend Index seeks to measure the performance of the 60 least-volatile high dividend-yielding stocks in the S&P SmallCap 600 Index.
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 Global Industry Classification Standard was developed by and is the exclusive property and service mark of MSCI, Inc. and Standard & Poor's.
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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 PowerShares blog by an Invesco employee on April 13, 2017: https://www.blog.invesco.us.com/examining-factor-performance-first-quarter-2017/