Size and Valuation Factors
Market preferences have changed steadily since September 2020. Small-cap has gained more than large-cap, and value stocks have appreciated more than growth stocks. We illustrate these facts in two graphs from stockcharts.com.
The first graph shows the total return of large-, mid- and small-cap ETFs (SPY, MDY, IWM). Clearly, during the first half of the year the returns were not significantly different, while for the last six months the returns of small-cap, IWM, were substantially higher.
The second graph shows the total return of small-cap value, small-cap blend, and small-cap growth ETFs (IJS, IJR, IJT). We see that the return of value stocks, IJS, was substantially higher than that of growth stocks, IJT, or blend stocks, IJR.
To get a better understanding of the dynamics of changes in market preferences, we looked at the evolution of total returns of small value and large growth stocks.
Since September 2020 the small value stocks returned 65%, easily beating the large growth group, which returned only 15%. A detailed comparison of total returns of a small value ETF, IJS, and a large growth ETF, IWF, is shown in the table below.
7/2000 - 9/2007 | 10/2007 - 2/2009 | 3/2009 - 12/2016 | 1/2017 - 9/2020 | 10/2020 - 3/2021 | |
IJS Small Value | 150% | -56% | 210% | 0% | 67% |
IWF Large Growth | -18% | -50% | 205% | 130% | 15% |
IJS - iShares S&P Small-Cap 600 Value ETF
The fund invests in small-capitalization stocks with relatively lower valuations.
As of 24 March 2021, IJS has net assets of 11.97B and 2.19% yield. The YTD total return is 16.50%, with a low expense ratio of 0.15%.
We compare some important statistics of IJS with a set of comparable small value ETFs.
Assets | P/Book | P/Sales | P/CashFlow | P/E | Expense Ratio | |
IJS | 7.9B | 1.41 | 0.83 | 6.4 | 18.05 | 0.18% |
VBR | 41.49B | 1.92 | 1.16 | 9.16 | 18.65 | 0.07% |
IWN | 14.52B | 1.48 | 0.96 | 7.01 | 15.68 | 0.19% |
SLYV | 3.67B | 1.59 | 0.94 | 7.71 | 19.06 | 0.15% |
We see that IJS has the lowest valuations among this set, the lowest Price/BookValue, Price/Sales, Price/CashFlow and second lowest Price/Earnings.
As a buy-and-hold investment, IJS has the best performance among the small-cap value funds. In the table below we present the buy-and-hold results over the period July 2004 - March 2021.
Fund | Initial Balance | Final Balance | CAGR | Stdev | Max DD | Sharpe ratio |
IJS | $1,000 | $4,958 | 8.07% | 25.26% | -60.10% | 0.27 |
VBR | $1,000 | $4,684 | 7.77% | 23.85% | -62.01% | 0.28 |
IWN | $1,000 | $4,014 | 6.97% | 25.27% | -61.52% | 0.23 |
SPY | $1,000 | $4,964 | 8.08% | 19.09% | -55.16% | 0.37 |
Momentum Strategy
The simplest portfolio invests in a value or growth fund during market risk-on periods and in a Treasury fund during market risk-off. We simulated the performance of such a portfolio for the period from January 2008 to March 2021.
We selected as the growth fund one of the following funds: IWF, VUG, SPYG. As the value fund we use one of the following funds: IJS, VBR, IWN, IVE.
Here we apply the same version of the dual-momentum strategy used in our latest articles. We use a dual-momentum strategy with two regimes: risk-on and risk-off. During risk-on periods, the funds are allocated to equity assets. The equity assets are selected based on their relative strength over a 65-day interval. During risk-off periods, the strategy invests all the funds in the iShares 7-10 Year Treasury Bond ETF (IEF).
As before, we generate signals for market state by using the following ETFs:
- Invesco DB Base Metals Fund (DBB)
- Invesco DB US Dollar Index Fund (UUP)
- Consumer Discretionary Select Sector SPDR Fund (XLY)
- Consumer Staples Select Sector SPDR Fund (XLP)
Therefore, the condition that must be satisfied for switching to risk-off allocation is that the return of DBB is smaller than that of UUP and simultaneously, the return of XLY is smaller than that of XLP over the absolute strength evaluation period. The absolute strength evaluation period used in this article is 65 trading days, the same as the period used for relative strength of the assets.
The transition from risk-on to risk-off is made the following trading day after the condition for market-off is simultaneously satisfied by both pairs: (DBB, UUP) and (XLY, XLP).
The reverse transition from market-off to market-on is done when the return of either pair has become positive, i.e. either the 65-day return of either DBB or XLY is higher than the corresponding return of UUP or XLP. The switch to risk-on is executed after a delay of two days after the risk-on condition is detected.
During risk-on periods we either keep the initial allocation unchanged, or rebalance the portfolio on the last trading day of each quarter if the relative strength of the portfolio assets requires a change.
Simulation Results
Simulation is done with the following four portfolios:
- [IJS-IVW-IEF]
- [VBR-VUG-IEF]
- [IWN-SPYG-IEF]
- [IVE-IVW-IEF]
Over the thirteen-year period from 1/1/2008 to 3/23/2021, there were 48 regime changes. The market was in risk-off for 944 trading days and in risk-on for 2388 days. The last change in allocations happened on 12/30/2020 when it switched from 100% in the growth fund to 100% in a value fund.
Portfolio | Initial Balance | Final Balance | CAGR | Stdev | Max DD | Sharpe ratio | YTD% |
[IJS-IVW-IEF] | $1,000 | $9,042 | 18.12% | 15.83% | -17.97% | 1.09 | 23.03% |
[IVE-IVW-IEF] | $1,000 | $7,612 | 16.59% | 13.49% | -13.74% | 1.18 | 10.78% |
[VBR-VUG-IEF] | $1,000 | $8,700 | 17.78% | 15.29% | -17.67% | 1.11 | 17.70% |
[IWN-IVW-IEF] | $1,000 | $8,191 | 17.24% | 15.61% | -18.32% | 1.05 | 19.33% |
To appreciate the effect of momentum allocation, we present a graph of the equity of the portfolio with momentum vs. the buy-and-hold of the S&P 500 and the IJS funds.
The next graph illustrates the size factor effect by displaying the equity curves of a portfolio with small value IJS along with that of a large value IVE. We see that small value outperformed most of the time between 2017 and 2021.
Market State Indicators
The indicators used in this article, DBB vs. UUP and XLY vs. XLP are in the risk-on state. The 3-month return of the base metals, DBB (10.28%), is larger than the corresponding return of the US dollar index, UUP (2.21%). Similarly, the 3-month returns of XLY (5.80%) is higher than that of XLP (4.20%). The differences of returns have been narrowing lately, but they are still positive.
The US leading economic index (LEI) is at 110.5 and has been increasing every month since May 2020.
The US High Yield Option-Adjusted Spread is currently 3.48, having increased in the last four weeks from a low level of 3.40. That small change does not negate the overall downtrend started in April 2020 at 10.87.
VIX, the S&P 500 implied volatility index, oscillates in a narrow range at moderately high levels, around 20. The VIX range over the last week is from a low of 18.86 to a high of 23.55.
The yields of long term bonds continue to increase, reaching around 1.70% for 10-year Treasury bonds, and 2.40% for 30-year Tbonds. The current Fed policies support economic growth and markets enjoy good access to capital. That is a good base for improving market fundamentals with continued earnings growth.
Conclusions
The indicators suggest that the markets are in risk-on state and that small value stocks outperform. Therefore, we believe that now is a good time to invest in value funds and IJS is a good choice among the small-cap ETFs.
We do not know how the market will behave in the near future. Based on historical evidence we expect periodic switching of leadership between value and growth. We believe that a momentum strategy has good chances of delivering strong results.
