Factor Tilt Performance In April's Rebound

Summary

• In past articles, I have illustrated for Seeking Alpha readers how seven factor tilts or alternative weighting schemes to the traditional large capitalization-weighted index have produced historical outperformance.
• I hope a display of these returns and a brief discussion about why these factor tilts deviated from the broader market can help readers with their asset allocation decisions.
• In the April rebound, factors that have lagged - value, equal-weighting, size - moved back to the forefront, at least in the short-run.
• Low Volatility was the weakest performer in the rebound, and is now trailing on the year. Momentum and Quality lagged slightly in April, but have still outperformed over last 3-6 months.
• Dissecting the sharp market move into its factor components could be useful to investors evaluating where to deploy capital.

The first quarter of 2020 saw the worst performance (-19.6%) since the dreaded fourth quarter of 2008 during the height of the Financial Crisis. April 2020 bounced back with the best monthly return (+12.8%) since January 1987. Beaten-down Value did even better, returning 14.6%. As the markets continue to price and re-price the economic impact of the shut-down aimed at slowing the spread of the virus, we are likely to continue to see heightened volatility.

The S&P 500 (SPY) has not been a bad place to be within equity markets during this particular crisis. The large cap index is populated largely by companies with the scale to weather an economic dislocation, and the balance sheet heft to ensure that a reduction in near-term liquidity does not impair the franchise's longer-term value. Throw in a 25.5% weight to Tech, a 15.3% weight to Healthcare, and a 4.0% weight to e-commerce and cloud computing giant Amazon (AMZN), and the capitalization-weighted index has been allocated well from an industry perspective for a public health crisis that has led to an uptick in online work and e-commerce.

Over longer-time intervals, the capitalization-weighted large cap index has still lagged a number of factor tilt strategies. While it may seem like the biggest companies only get bigger in the current episode, owning large cap companies weighted by their market capitalization has not delivered outpeformance over the course of several business cycles. These alternative factors to the traditional capitalization-weighting outperform in different parts of the economic cycle, and this series aims to discuss what has worked, and what might be more likely to work, moving forward.

In the table below, I have listed the performance of seven factor tilts and the capitalization-weighted benchmark over trailing 1, 3, and 6 months, as well as, 1, 3, 5, 10, and 20 years. Information below is from the underlying indices for these strategies. These strategies have delivered structural alpha for investors over multiple business cycles.

Below I have listed the performance of exchange-traded funds that replicate these factor indices. Given the more recent inception dates of these funds, we do not have the full histories that we have for the underlying indices above, which is why I continue to show both in this series. These are certainly not the only ways to get exposure to these factors, and increasing competition in the realm of smart beta is likely to continue to further push down expense ratios in the industry going forward. Value (NYSEARCA:RPV), Low Volatility (SPLV), Dividend Growth (NOBL), Equal-Weighting (RSP), and Quality (SPHQ) draw from the S&P 500 (SPY) - they are simply alternative weightings to that traditional capitalization-weighted index. Size (IJR) draws from a separate Standard and Poor's index, the small-cap S&P 600 index. Momentum (MTUM) draws from the broader MSCI USA Index.

For these seven factors and the S&P 500, I have also calculated the standard deviation of monthly returns. In this series, I am using this volatility measure as a risk proxy. While some buy-and-hold investors may counter that they have a long-term view and are not impacted by market volatility, unfortunately, many individual investors all too often can be whipsawed by market swings.

Some investors may prefer strategies with less variability of returns like Low Volatility and Dividend Growth. I think these calculations give readers a feel for the volatility differences in the various strategies. We will also track this measure to ensure that these strategies are delivering on their promise of a smoother return profile. Dividend Growth, a strategy that has bested the broad market in at least the last six negative years for the S&P 500, is lagging in 2020 without meaningfully lower realized volatility, a historical anomaly. After April's underperformance in the market rebound, Low Volatility is now lagging as well from an absolute return perspective, but has delivered lower volatility as advertised.

Discussion Of Recent Performance

Value was the best performer on the month (14.6% return versus 12.8% for the S&P 500), reversing part of its tremendous year-to-date underperformance. Perhaps surprising for a month that saw front end oil futures contracts trade sharply negative, the strategy's overweight to Energy drove almost all of its monthly outperformance as the commodity-sensitive sector was the top performing sector in the S&P 500. Value is overweight Financials, Energy, Materials stocks, and the brick-and-mortar part of Consumer Discretionary. While it is a motley crew of sector allocations in the current environment, depressed valuations could leave it well positioned to outperform when the recovery ultimately comes. As I wrote recently, Value tends to outperform in early recovery periods, strongly besting the S&P 500 in the year after stocks bottomed in 2002 and 2009

Equal-weighting also outperformed, posting a 14.4% return. In "Strategies to Buy the Dip", I highlighted that simply equal-weighting the S&P 500 components instead of their traditional capitalization-weighting has led to sharp outperformance in the year after stocks bottom. The trillion dollar question for markets, of course, is have stocks really bottomed? Looking forward over an intermediate horizon of 3-5 years, I believe that equal-weighting has a meaningful chance to outperform capitalization-weighting as the contrarian rebalancing overweights stocks that have been disproportionately hurt by the crisis and smaller companies regain their footing.

Speaking of smaller companies, the Small Cap Index posted a strong 12.7% return on the month, but actually lagged the S&P 500 slightly after giving up its relative gains on the last day of the month. Like Value and Equal-Weighting, Size is a strategy that has outperformed in early recovery periods as stocks have bottomed.

Quality, which has outperformed year-to-date, posted a 12.3% return in April, slightly lagging the S&P 500. For the full year through April, the strategy has shed just 7.5%. Unique among other defensive strategies like Low Volatility and Dividend Growth, the Quality strategy, which screens components on return on equity, financial leverage, and accruals ratio, has an overweight to Tech, which makes up over 36% of the fund.

Momentum has also outperformed year-to-date, but lagged slightly in April. The strategy had lost less than 5% through the end of April. An overweight to Tech and a growing overweight to Healthcare has contributed to the strategy's outperformance. With a sharp reversal in economic sentiment, Momentum could have been subject to a sharp correction if it was overweight economically-sensitive sectors, but the strategy was positioned rather defensively and has only increased that bent through rebalancing. The strategy may lag during the economic rebound, but holders have been rewarded with relative outperformance thus far.

As noted in Friday's article on the performance of the Dividend Aristocrats, the strategy had its best monthly performance since April 2009, but still lagged the broad market. The strategy has outperformed in at least each of the last six down years for the market, but is lagging thus far in 2020. The strategy's equal-weighting of its constituents could encourage a rebound as it rebalances towards underperforming constituents.

Low Volatility was the worst performer on the month. While this is not necessarily surprising in a month of sharp gains, the size of the outperformance was meaningful. Low Volatility lagged the broader S&P 500 by just over 6% on the month, its largest level of monthly underperformance since January 2001. The strategy is now lagging through April after outperforming through the first quarter. Overweights to Utilities, Financials, and REITs - each of which lagged the index in April - contributed to the underperformance.

I hope this discussion of the performance of the factor tilt strategies aids in readers' understanding of the drivers of their relative returns. It was yet another historic month with unique relationships between the factors abounding. As stocks rallied, strategies that tend to do well in early recovery periods - value, size, equal-weighting - did quite well, but tech-centric strategies also continued strong performance. Hopefully, sector level reviews of performance drivers can aid portfolio positioning moving forward.

Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties, and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.

Analyst’s Disclosure: I am/we are long RPV, IJR, SPLV, NOBL, RSP, MTUM, SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.