The reflation trade was the dominant story in global capital markets in February 2021, and the theme impacted both the factor tilt winners and losers. On the positive side, the "buy the dip" strategies I espoused last April continue to outperform as market participants increasingly price in an economic recovery.
In a mini-series of articles beginning on April 17th, 2020 I highlighted for investors strategies to "buy the dip". I commented that timing the bottom is always a challenge, but that investors do know what strategies have worked the best from previous bottoms when the market has recovered. That article highlighted opportunities in Size, Value, and Equal-Weighting. Those three strategies have dramatically outperformed the broad market since the March 2020 lows. Since March 23rd, 2020, the S&P 500 is up 73%, including reinvested dividends. An equal-weighted version of the index is up nearly 90%. A value-focused tilt to the S&P 500 constituents is up 109%. The S&P Smallcap 600 is up 118%. In February 2021, those three strategies were again winners, posting 6 to 10.6% monthly returns that doubled or tripled the broad market return.
While these small-cap and value focused strategies have done well in a reflationary environment, others have lagged. Low Volatility, which is comprised of lower risk stocks that tend to have more fixed income-like characteristics, lagged appreciably as rates rose in February. Momentum, one of the big winners of 2020, due in part to bets on tech and other tech halo stocks, also lagged on the month. Historically, tech stocks have done poorly when real rates rise, and February 2021 saw the sector slightly underperform. The Momentum strategy, which has rode that sector to market-beating gains, weakened as well.
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 as depicted through the 20-year returns at the bottom of the table.
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 S&P Small Cap 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 lagged in 2020 without meaningfully lower realized volatility, a historical anomaly. Low Volatility is a decided laggard over the last year, meaning its lower realized volatility offers cold comfort to investors like me. Value and Size have begun to strongly outpace markets broad markets over the past six to nine months; investors should understand that these strategies tend to come with higher realized volatility.
Discussion of Recent Performance
Value was the big winner in February, up more than 10.6% on the month. The strategy has strongly outperformed since the March 2020 lows, nearly reversing the sharp underperformance during that large drawdown. Two of the sector overweights that hurt the strategy during the 2020 drawdown - Financials and Energy - were two of the big winners in February 2021. Higher interest rates and higher oil and gas prices boosted both sectors. The Financials overweight (41.1% weighting for the Value Index vs. 10.7% for the S&P 500) drove 3.4% of the 7.8% outperformance for the value-focused strategy on the month. Energy (9.5% Value weight vs. 2.6% S&P 500 weight) drove an additional 1.7% outperformance on the month. The value strategy has now outperformed the broad S&P 500 for six consecutive months, the longest streak since 2013.
Size was the second biggest outperformer on the month as small caps continue to outperform large caps. The S&P SmallCap 600 returned 7.65% versus the 2.76% of the S&P 500 in February. Small caps have returned over 50% in just the past five months, a stretch of gains even greater than the early recovery from the Financial Crisis.
Perhaps unsurprisingly, Equal-Weighting posted the third highest returns on the month. After all, equal-weighting is a tilt towards smaller capitalization stocks than the cap-weighted index. The strategy's contrarian rebalancing, which adds more to underperforming components, is a value-like strategy. An equal-weighted version of the S&P 500 returned 6.08% in February as the capitalization-weighted index returned just 2.76%. Since equal-weighting and capitalization-weighting own the exact same constituents - albeit with different weights - their performance is necessarily linked. February 2021 was just the 14th month since 1990 that equal-weighting has beat capitalization-weighting by more than 3% on a month. Two of those months - February 2021 and November 2020 - have come in the last four.
Dividend Growth narrowly outperformed the S&P 500 as well. The strategy can struggle on a relative basis in rising interest rate environments because stable dividend payers can have more fixed income-like properties. The outperformance in February 2021 was in part driven by a reversal of a driver of 2020's underperformance. The strategy is naturally underweight Tech and tech-like business, which lagged on the month after outperforming for much of the past year.
Quality, was a strong performer in 2020 given its tilts towards tech and healthcare. In February 2021, the modest underperformance for the strategy (-78bp) was driven in larger part by the Healthcare overweight.
Momentum was a stalwart in 2020, returning nearly 30%, but the strategy produced a -0.59% return in February. Tesla (TSLA) alone contributed to 60bp of underperformance as the stock (7.08% weight in Momentum versus 1.85% in the S&P 500) as the stock swooned nearly 15%. Underweights to Energy and Financials, two sectors that drove Value's outperformance, also weighed down monthly performance.
While Momentum and Low Volatility both select stocks based on trailing performance, Momentum rode the hot hand in sector allocation and security selection in 2020 while Low Volatility faced poor sector allocation into the downturn and was too risk-averse during the subsequent rally. In February 2021, the strategy lagged in part due to its interest rate sensitivity.
In my Market Themes for 2021, I noted: "A rotation from the megacap tech leaders to underperforming sectors and smaller capitalization companies is a key performance driver" for U.S. equity markets. In the first two months of the year, at least, that has borne out correctly with small caps and value stocks leading and tech lagging in February. The relative gains of value and small-caps over the past several months are becoming so large that further analysis may be warranted to examine if these strategies are likely to cool off in the short-run. For those placing bets that the reflationary trade can continue, this article should help understand how that trade is playing out among various market factor tilts.
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.