08/17/16   Factor Rotation

Editor’s Corner

Ron Rowland

Investment methodologies that select and weight portfolio securities by factors other than market capitalization have been around for decades. Personally, I have relied heavily on the momentum factor since the mid-1980s. However, many investors have become aware of these alternative investment approaches only over the past few years. I believe that the recent acceptance of smart-beta ETFs by the financial media has been one of the driving forces behind this change.

In the early 1990s, Eugene Fama and Kenneth French introduced a three-factor investment model based on company size, price-to-book ratio, and market risk. Although many notable mutual fund and institutional investors had been using multifactor models for years, Fama and French were among the first to publish their underlying research.

The advent of ETFs has made it easier for product developers to roll out new ideas and repackage existing approaches for general consumption. Equal weighting, dividend weighting, fundamental weighting, and other portfolio-construction techniques have quickly become available in a convenient ETF wrapper. Some sponsors brought out products focusing on just a single factor such as yield, volatility, or momentum. Others put together various combinations of multifactor ETFs.

Earlier this decade, Towers Watson coined the term “smart beta” as a way to identify good investment ideas that can be structured better. Although the descriptive accuracy and the actual definition are subject to debate among investment professionals, the term has caught on in the financial world. As a result, smart-beta investing is becoming more mainstream every day.

Today, sponsors are rolling out multifactor smart-beta ETFs by the truckload. Low volatility and dividend yield have been two well-performing factors the past few years. As a result, there is an abundance of new offerings combining these two factors. Other sponsors are diligently searching for the “best” combinations of four, five, six, or more factors to package into a single product.

However, these products all tend to overlook one thing: factors rotate. Just like various sectors come into and out of favor, so do investment factors. In the late 1990s, earnings momentum was the dominant factor. After the dot-com bubble, the value factor was king. Eight years ago, as the financial crisis was unfolding, yield became the prime factor.

For the past six weeks, beta has been the primary factor driving performance, and a portfolio constructed of high-beta stocks would have likely outperformed most other methodologies. Investors wanting to exploit this concept can use single-factor ETFs such as PowerShares S&P 500 High Beta (SPHB) to their advantage. SPHB owns the 100 stocks from the S&P 500 Index with the highest 12-month beta. The ETF has outperformed the SPDR S&P 500 ETF (SPY) by about 8% since June 27 (about six weeks). Be sure you have an exit plan before you run out and buy it though, because SPHB underperformed SPY by 14% in 2015 when the beta factor was out of favor.

Signs of a massive sector rotation are starting to appear. Three of the top four categories this week were nowhere to be found a couple of weeks ago, and the former leaders have sunk into the edgecharts-2016-08-17abyss. Technology now has a firm grip on the leadership role after struggling along in ninth place just four weeks ago. It has a substantial margin over the next half-dozen sectors, which are tightly clustered in the rankings. There is a steep fall off at the other extreme, with Telecom barely holding on to a sliver of positive momentum, while Utilities has already succumbed to the downside. For the sectors that gained relative strength this week, Materials moved from third to second, Industrials climbed three places to third, and Energy jumped from ninth to fourth. Consumer Discretionary and Consumer Staples posted modest improvements and each moved a notch higher. Some of the downside moves were fierce, as Real Estate plunged from second to eighth, Health Care gave up two spots, and Telecom slipped from sixth to 10th.

Changes in the style rankings were quite mild this week, especially when compared to the sector realignments. The three-way tie for first place among the Small-Cap categories carried over another week, but due to fractional differences in momentum scores, Small-Cap Value moved to the top of the heap and pushed the other two lower. Micro-Cap held on to its fourth-place ranking, keeping the four smallest-capitalization segments firmly at the top. Mid-Cap Growth climbed two spots to seventh, putting the three Mid-Cap categories together in the middle. Mega-Cap fell two spots, and now the four largest-capitalization segments are together at the bottom.

With all of the media focus on U.S. markets making new highs, you might not be aware that the U.S. is one of the worst-performing global categories. The U.S. dropped from sixth to 10th this week, with the U.K. being the only category ranked lower. The developing markets are getting most of the upside action in the current environment. Latin America continues to tack on the gains, and this week China zoomed into second place. The diversified Emerging Markets category makes for a developing markets trifecta at the top of the rankings. The rise of China pushed Pacific ex-Japan a spot lower, and there is now a significant gap between it and the higher-ranked categories. Canada jumped from eighth to fifth on strength in the Energy and Materials sectors. Japan slipped a spot, while World Equity and EAFE held steady. The Eurozone posted a strong week and climbed two places to eighth. As previously mentioned, the U.S. fell to 10th place despite stocks hitting new all-time highs. The U.K. remains the laggard among our major global categories, as Brexit-related currency concerns are offsetting price gains for stocks.



The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.


“As with most new expressions, ‘smart beta’ is in the process of seeking an established meaning. It is fast becoming one of the most overused, ill-defined, and controversial terms in the modern financial lexicon.”

Rob Arnott and Engin Kose of Research Affiliates


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