My colleague, Dan Draper, recently wrote about the growing interest in factor-based investment strategies, as advisors and clients consider whether and how factor ETFs might fit into their portfolios. This week, we look at specific factors that may be significant over the next six to 12 months and examine some of their investment applications for advisors and investors.
As Dan noted, all asset classes carry broad forces, including volatility, momentum, size, value and quality, that can protect against risk and contribute to returns. These underlying building blocks, or factors, can also be combined to help investors target different portfolio outcomes across a range of economic conditions. And it’s no secret that today’s economic conditions leave advisors in an uncertain investment environment, with both positive and negative trends to consider.
The economy, which has been recovering slowly and unevenly since the depths of the recession in 2009, is confronting a number of significant challenges. Financial markets are filled with uncertainty over European integration; European banks continue to struggle with profitability; China’s deleveraging processes remain unclear, and geopolitical and terror risks are ever looming.
In the U.S., structural and regulatory hurdles to growth remain. Amid signs of rising inflation, the Fed continues to drag its feet in raising interest rates, despite having met its unemployment targets, and the upcoming presidential election is causing additional unease.
On the positive side, there is a strong chance that the growth rate in S&P 500 earnings made a trough in the second quarter of 2016 and we may rise from here into 2017. Sustained job growth, improved readings in the economy-weighted ISM, signs of decline in the inventory-to-sales ratio, the reduced dollar strength, and robust consumer spending are all favorable signs for potential future earnings growth.
Why Low Vol and Value May Be Big Factors for 2016-2017
For advisors, better growth prospects and low interest rates argue for having equity exposure, and this opens the door to combining factors that are inversely related in order to construct more resilient portfolios. The low-volatility factor, for example, has tended to perform best in periods of sluggish growth, characterized by falling or low interest rates, high or rising market volatility, high to rising credit risk, and weak market conditions. In contrast, the value factor has historically liked periods of strong or accelerating growth and rising interest rates.
Forecasts of a strengthening economy heading into 2017 might therefore be positive for a value tilt and weigh on the low-volatility factor. The multitude of risks that remain, however, would argue for hazard management through a continued exposure to low volatility. The inverse trend between these two factors suggests that combining a low-volatility index and a value index would be an interesting portfolio solution. The low-volatility factor could be used to mitigate or manage economic and political risks, while the value factor might benefit portfolio returns if the economy does find firm footing and accelerate in 2017.
Identifying Factors in an Uncertain Economy
Low-volatility and value factors also display a relationship to trends in the VIX, or the CBOE Volatility Index. Popularly referred to as the fear index, the VIX represents a measure of the implied volatility of S&P 500 index options. A falling VIX tends to put pressure on excess returns derived from low volatility, while benefiting excess returns from the value factor.
Likewise, a rising VIX may lift the excess returns of low volatility, while adding pressure on any excess returns of the value factor. Although there is no certainty to the relationship between these factors and the VIX, it does underscore how the environment can impact factor returns and provides advisors with another source of data for identifying trends.
When evaluating factor-based ETFs, advisors need to be mindful of how factor exposures align with the investment goals of their clients. Over time, the top performers among factor-based funds change, and investors need to be aware that a given factor’s performance may not match expectations.
Keeping these caveats in mind, advisors may find that combining investment factors that display inverse trends, such as low volatility and value, can potentially result in compelling risk-adjusted returns through higher returns, lower risk or both. Deploying these options may then enable their clients to chart an appropriate course through the uncertain economic and political terrain that lies ahead.