Factor returns displayed a wide dispersion in the third quarter, with a 12.2% spread between the best-performing factor index (Russell Midcap Pure Growth) and the worst-performing factor index (S&P 600 Pure Value). Year to date, the spread is a hefty 31.0%.1 What does this mean? Investors who judge the equity market based on traditional benchmarks may not realize the market opportunities that are present “underneath the hood” via factors.
The Q3 factor winners
Momentum and growth continued to display strong performance in the third quarter. Mid-cap growth, momentum, and small-cap growth (as defined by the Russell MidCap Pure Growth Index, S&P 500 Momentum Index, and Russell 2000 Pure Growth Index) outperformed the S&P 500 Index.
- The macro environment was conducive to growth and momentum as economic output was buoyant, equity volatility was low, and correlation declined and remained at low levels.
- From an attribution standpoint, momentum benefited from the S&P 500 Momentum Index’s stock selection in consumer discretionary and sector allocation to information technology. Every sector contributed to generating excess return.
- Mid-cap growth generated its excess return most pointedly through the Russell MidCap Pure Growth Index’s IT holdings, while small-cap growth’s strong performance was most clearly driven by health care and IT in the Russell 2000 Pure Growth Index.
A factor is a measurable characteristic of an investment that helps explain its performance.
Academic research has shown that certain equity factors have the potential to outperform the broad market over the long term (even while they may have bouts of short-term underperformance). In particular, research has identified six main “rewarded” equity factors:
- Low volatility
- Dividend yield
Other factors may not display the same potential for long-term outperformance, but their potential for short-term outperformance may make them useful for tactical exposures in a portfolio. These factors include growth and high beta, for example.
To show the large difference in factor performance in various market environments, we list a comprehensive range of factors in our quarterly analysis.
In addition to the strong performance by momentum and growth, three other factors outperformed the S&P 500 Index as well: quality (S&P 500 Quality Index), dividend yield (Dow Jones Average Yield Weighted Index) and buyback (NASDAQ Buyback Achievers Index).
- The excess return for quality was mostly a function of the S&P 500 Quality Index’s allocation and selection in energy and communication services. In contract, allocation to health care was a headwind to return.
- Selection in communication services and health care for the Dow Jones Average Yield Weighted Index were the largest positives for dividend yield. The underweight and selection IT was the largest drag.
- Buyback outperformed the S&P 500 Index marginally. Selection in communication services and allocation and selection in energy were most positive for the NASDAQ Buyback Achievers Index. Poor selection in consumer discretionary was a negative.
Factor index returns (sorted by Q3 performance)
|Factor||Index||Q3 2018||YTD 2018 (as of Sept. 30)|
|Growth (Mid-Cap)||Russell Midcap Pure Growth Index||12.19%||29.39%|
|Quality||S&P 500 Quality Index||9.87%||9.35%|
|Momentum||S&P 500 Momentum Index||9.75%||19.48%|
|Growth (Small-Cap)||Russell 2000 Pure Growth Index||9.29%||24.96%|
|Dividend Yield||Dow Jones Industrial Average Yield Weighted Total Return Index||8.90%||8.49%|
|Buyback||NASDAQ Buyback Achievers Index||7.92%||4.61%|
|S&P 500 Index||S&P 500 Index||7.71%||10.56%|
|Multi-Factor (Large Growth)||Dynamic Large Cap Growth Intellidex Index||7.71%||17.50%|
|Momentum (Mid Large)||Dorsey Wright® Technical Leaders Index||7.71%||15.51%|
|Growth||Russell Top 200 Pure Growth Index||7.63%||20.95%|
|Low Volatility/Rising Rate||S&P 500 Low Volatility Rate Response Index||7.57%||8.58%|
|Equal Weight||S&P 100 Equal Weight Index||7.36%||7.34%|
|Minimum Variance||S&P 500 Minimum Volatility Index (net total return)||6.88%||7.41%|
|Sector Rotation||Dorsey Wright Sector 4 Total Return Index||6.86%||12.25%|
|Momentum (Small-Cap)||Dorsey Wright® SmallCap Technical Leaders Index||6.77%||18.77%|
|Fundamental||FTSE RAFI US 1000 Index||6.09%||6.47%|
|Multi-Factor||Dynamic Market Intellidex Index||5.98%||13.53%|
|Growth (Small-Cap)||S&P Small Cap 600 Pure Growth Total Return Index||5.89%||18.56%|
|Value||S&P 500 Enhanced Value Index||5.73%||3.46%|
|Multi Factor (Large Value)||Dynamic Large Cap Value Intellidex Index||5.67%||-1.62%|
|Value & Momentum||S&P 500 Value Momentum Index||5.60%||2.98%|
|Equal Weight||S&P 500 Equal Weight Index||5.42%||7.28%|
|Value||S&P 500 Pure Value Total Return Index||5.17%||5.53%|
|High Beta||S&P 500 High Beta Index||5.08%||7.42%|
|Low Volatility||S&P 500 Low Volatility Index||5.04%||5.79%|
|Growth||S&P 500 Pure Growth Total Return Index||5.04%||15.31%|
|Equal Weight||Russell 1000 Equal Weight Index||4.82%||7.80%|
|S&P 600 Index||S&P SmallCap 600 Index||4.71%||14.54%|
|Low Beta Equal Weight||Russell 1000 Low Beta Equal Weight Index (total return)||4.54%||7.43%|
|Value||Russell Top 200 Pure Value Index||4.46%||3.64%|
|S&P 400 Index||S&P MidCap 400 Index||3.86%||7.49%|
|Low Volatility (Mid-Cap)||S&P MidCap 400 Low Volatility Index||3.86%||8.61%|
|Equal Weight (Small-Cap)||S&P SmallCap 600 Equal Weight Index||3.28%||13.33%|
|Equal Weight (Mid-Cap)||S&P MidCap 400 Equal Weight Index||3.26%||7.40%|
|Dividend Growth||NASDAQ Dividend Achievers 50 Index||3.00%||4.03%|
|Low Volatility (Small-Cap)||S&P SmallCap 600 Low Volatility Index||3.00%||8.61%|
|Fundamental (Mid Small)||FTSE RAFI US 1500 Mid Small Index||2.63%||10.55%|
|Dividend Yield & Low Volatility||S&P 500 Low Volatility High Dividend Index||2.11%||0.94%|
|Value (Mid-Cap)||Russell Midcap Pure Value Index||1.81%||1.98%|
|Value (Small-Cap)||Russell 2000 Pure Value Index||1.65%||7.41%|
|Low Vol/High Div (Small-Cap)||S&P SmallCap 600 Low Volatility High Dividend Index (total return)||1.36%||7.42%|
|Value (Small-Cap)||S&P SmallCap 600 Pure Value Total Return Index||-0.05%||6.74%|
|Dispersion in factor return||12.24%||31.01%|
Source: Bloomberg. L.P. as of Sept. 30, 2018. Investments cannot be made directly into an index. Past performance is not a guarantee of future results.
Small-cap value and mid-cap value were among the worst performing factors, along with indexes that combined low volatility and high dividend.
- Poor selection in consumer discretionary and weak selection and allocation in health care and IT created a drag on the small-cap S&P 600 Pure Value Total Return Index.
- The mid-cap Russell 2000 Pure Value Index was hurt most notably by its allocation and selection to financials and health care.
- Rising rates and robust economic growth, along with the strength in technology shares, created a headwind for the low volatility/high dividend combo.
- The flatter yield curve and competitive lending environment have hurt profitability for banks, and the KBW Regional Bank Index lagged in the third quarter, falling 3.13%.1 This created weakness in the value factor (banks have been displaying the value factor given their low price-to-earnings and price-to-book multiples compared to the overall market). As of Sept. 30, the Russell 2000 Value Index was overweight regional banks and thrifts and mortgages by nearly 14% (and underweight technology by nearly 15%) compared to the Russell 2000 Growth Index.1
At the end of the third quarter, the CBOE S&P 500 Implied Correlation Index was at the lowest level in its history going back the global financial crisis, while the VIX volatility index was low at 12.12.1 (From Jan. 1, 1990, to Sept. 30, 2018, the VIX recorded average and median values of 19.1 and 17.1, respectively).1Although I expect the economy’s strength to help place a ceiling on volatility and correlation, the lagged impact of US Federal Reserve tightening and recent dollar strength may act as a floor. Moreover, readings in the ISM Manufacturing Index near 60 have typically been consistent with a cycle peak, and this indicator was at 59.80 at the end of the third quarter.1 In short, correlation and volatility are unlikely to stay low forever and are subject to mean reversion, in my view, while economic growth is poised to slow.
So, what could this mean for factors?
- The momentum and growth factors may be in the later innings of their outperformance given the possibility that we’re near a cycle peak.
- Quality typically performs well later in the market cycle, and therefore has the potential to be a leader in 2019 as year-ago profit growth comparisons may become more difficult and Fed tightening measures may bite more dramatically. Quality firms typically have greater financial health than lower quality firms do, and as a result may be better able to handle slower growth conditions.
- Low volatility could also benefit if there are clear signs of economic weakness and defensive positioning as the economic cycle heads lower.
- Beyond pure economics, uncertainty over trade with China, the US mid-term elections, and Italian populism have the potential to sour confidence and generate bouts of volatility. The low volatility factor has historically outperformed the broad market in periods of high volatility, but the quality factor also possesses defensive characteristics and may benefit from continued economic expansion that is overlaid by periods of volatility.2
Explore more about factor investing.
Learn about Invesco’s factor strategies.
1 Source: Bloomberg, L.P., as of Sept. 30, 2018
2 Sources: Bloomberg, L.P., and Invesco, as of Sept. 30, 2018. From May 2011 through September 2018, the low volatility factor (S&P 500 Low Volatility Index) outperformed the S&P 500 Index by an average of 1.78% a month in high volatility periods (when the CBOE Volatility Index was over 22.5). From June 2010 through September 2018, the quality factor outperformed the S&P 500 Index by an average of 0.57% a month in high volatility periods (when the CBOE Volatility Index was over 22.5). The quality factor was defined by the Value Line Timeliness Select Index during the month of June 2010, by the S&P 500 High Quality Rankings Index from June 30, 2010, to March 18, 2016, and by the S&P 500 Quality Index from March 18, 2016, onward.
Blog header image: kram9/Shutterstock.com
Spread represents the difference between asset returns.
Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time.
Correlation is the degree to which two investments have historically moved in relation to each other.
Factor investing is an investment strategy in which securities are chosen based on certain characteristics and attributes.
Diversification does not ensure a profit or eliminate the risk of loss.
Low volatility cannot be guaranteed.
Momentum style of investing is subject to the risk that the securities may be more volatile than the market as a whole, or that returns on securities that have previously exhibited price momentum are less than returns on other styles of investing.
Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.
Investing in securities of large-cap companies may involve less risk than is customarily associated with investing in stocks of smaller companies.
A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.
About the indexes
The S&P SmallCap 600 Low Volatility High Dividend Index seeks to measure the performance of the 60 least-volatile high dividend-yielding stocks in the S&P SmallCap 600 Index.
The Russell 2000 Pure Value Index is composed of securities with strong value characteristics selected from the Russell 2000 Index. Securities are weighted based on their style score.
The S&P SmallCap 600® Pure Value Index measures the performance of securities that exhibit strong value characteristics in the S&P SmallCap 600® Index. Value is measured by the following risk factors: book value-to-price ratio, earnings-to-price ratio and sales-to-price ratio.
The Russell 2000 Pure Growth Index is composed of securities with strong growth characteristics selected from the Russell 2000 Index. Securities are weighted based on their style score.
The S&P SmallCap 600® Pure Growth Index measures the performance of securities that exhibit strong growth characteristics in the S&P SmallCap 600® Index. Growth is measured by the following risk factors: sales growth, earnings change to price and momentum.
The S&P SmallCap 600® Equal Weight Index equally weights small-cap securities in the S&P SmallCap 600® Index.
The Dorsey Wright SmallCap Technical Leaders Index includes securities pursuant to a Dorsey, Wright & Associates, LLC proprietary selection methodology that is designed to identify companies that demonstrate powerful relative strength characteristics. Approximately 200 companies are selected for inclusion from a small-cap universe of approximately 2,000 of the smallest US companies selected from a broader set of 3,000 companies.
The S&P SmallCap 600 Index is a market-value-weighted index that consists of 600 small-cap US stocks chosen for market size, liquidity and industry group representation.
The FTSE RAFI US 1500 Small-Mid Index is designed to track the performance of small and medium-sized US companies. Companies are selected based on the following four fundamental measures of size: book value, cash flow, sales and dividends. Each of the equities with a fundamental weight ranking of 1,001 to 2,500 is then selected and assigned a weight equal to its fundamental weight.
The S&P SmallCap 600 Low Volatility Index consists of 120 out of 600 small-capitalization range securities from the S&P SmallCap 600 Index with the lowest realized volatility over the past 12 months.
The Russell Midcap Pure Growth Index is composed of securities with strong growth characteristics selected from the Russell Midcap® Index. Securities are weighted based on their style score.
The Russell Top 200 Pure Growth Index is composed of securities with strong growth characteristics selected from the Russell Top 200 Index. Securities are weighted based on their style score.
The Nasdaq-100 Index® includes 100 of the largest domestic and international nonfinancial companies listed on the Nasdaq Stock Market based on market capitalization.
The S&P MidCap 400® Equal Weight Index equally weights mid-cap securities in the S&P MidCap 400®Index.
The Dynamic Large Cap Growth Intellidex Index seeks to provide capital appreciation while maintaining consistent stylistically accurate exposure. The Style Intellidexes apply a rigorous 10-factor style isolation process to objectively segregate companies into their appropriate investment style and size universe.
The S&P MidCap 400 Low Volatility Index consists of 80 out of 400 medium-capitalization range securities from the S&P MidCap 400 Index with the lowest realized volatility over the past 12 months.
The Dynamic Market Intellidex Index seeks to identify and select companies from the US marketplace with superior risk-return profiles.
The S&P 500 Momentum Index is designed to measure the performance of securities in the S&P 500 Index universe that exhibit persistence in their relative performance.
The Dorsey Wright Technical Leaders Index includes approximately 100 US companies from a broad mid- and large-capitalization universe. The index is constructed pursuant to Dorsey, Wright & Associates, LLC’s proprietary methodology, which takes into account, among other factors, the performance of each of the approximately 1,000 largest companies in the eligible universe as compared to a benchmark index, and the relative performance of industry sectors and sub-sectors.
The S&P 500 Low Volatility High Dividend Index is composed of 50 securities traded on the S&P 500 Index that historically have provided high dividend yields and low volatility.
The S&P 500® Pure Growth Index measures the performance of securities that exhibit strong growth characteristics in the S&P 500® Index. Growth is measured by the following risk factors: sales growth, earnings change to price and momentum.
The Russell 1000 Equal Weight Index captures the risk and return performance of an equal weight investment strategy for US large-cap stocks.
The NASDAQ US Dividend Achievers 50 Index is composed of 50 stocks selected principally on the basis of dividend yield and consistent growth in dividends.
The S&P MidCap 400 Index is an unmanaged index considered representative of mid-sized US companies.
The Russell 1000 Low Beta Equal Weight Index tracks US large-cap stocks that exhibit low beta, with all index constituents weighted equally within the index.
The Dorsey Wright Sector 4 Total Return Index selects up to four exchange-traded funds from the PowerShares DWA Momentum Sector lineup of ETFs with the objective of gaining exposure to the strongest relative strength sectors in the US equity space on a monthly basis.
The Russell Midcap Pure Value Index is composed of securities with strong value characteristics selected from the Russell Midcap® Index. Securities are weighted based on their style score.
The FTSE RAFI US 1000 Index is designed to track the performance of the largest US equities, selected based on the following four fundamental measures of firm size: book value, cash flow, sales and dividends. The 1,000 equities with the highest fundamental strength are weighted by their fundamental scores.
The S&P 500® Equal Weight Index equally weights the stocks in the S&P 500® Index.
The S&P 500® Minimum Volatility Index employs a managed-volatility methodology that seeks to achieve lower total risk than the S&P 500 Index, while maintaining similar characteristics. Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time.
The S&P 500® Pure Value Index measures the performance of securities that exhibit strong value characteristics in the S&P 500® Index. Value is measured by the following risk factors: book value-to-price ratio, earnings-to-price ratio and sales-to-price ratio.
The S&P 100® Equal Weight Index equally weights 100 major blue-chip companies across multiple industry groups in the S&P 500® Index.
The Dow Jones Industrial Average Yield Weighted Index is designed to provide exposure to high-yielding equity securities in the Dow Jones Industrial Average™ by their 12-month dividend yield over the prior 12 months. Only securities with consistent dividend payments over the previous 12 months are included in the index. The index is computed using the gross total return, which reflects dividends paid.
The S&P 500 High Beta Index consists of the 100 stocks from the S&P 500 Index with the highest sensitivity to market movements, or beta, over the past 12 months. Beta is a measure of relative risk and is the rate of change of a security’s price.
The S&P 500 Low Volatility Index consists of the 100 stocks from the S&P 500 Index with the lowest realized volatility over the past 12 months.
The Russell Top 200 Pure Value Index is composed of securities with strong value characteristics selected from the Russell Top 200 Index. Securities are weighted based on their style score.
The S&P 500 Quality Index screens holdings based on three fundamental measures of quality — profitability, earnings quality and financial robustness — which help to assess a company’s potential future profitability, as well as the financial risk each company faces.
The S&P 500 Low Volatility Rate Response Index is designed to measure the performance of the top 100 companies of the S&P 500 Index that have exhibited low volatility and are less sensitive to changes in interest rates.
The S&P 500 Enhanced Value Index is designed to measure the performance of the top 100 stocks in the S&P 500 Index with attractive valuations based on “value scores” calculated using three fundamental measures: book value-to-price, earnings-to-price and sales-to-price.
The NASDAQ US BuyBack Achievers Index is designed to track the performance of companies that meet the requirements to be classified as BuyBack Achievers. It is composed of US securities issued by corporations that have effected a net reduction in shares outstanding of 5% or more in the trailing 12 months.
The S&P 500® High Momentum Value Index tracks the performance of stocks in the S&P 500® Index that have the highest value and momentum score. Constituents are selected through a two-step process: first, the 200 stocks with the highest value scores; second, 100 securities with the highest positive momentum scores.
The Dynamic Large Cap Value Intellidex Index is designed to provide capital appreciation while maintaining consistent stylistically accurate exposure. The Style Intellidexes apply a rigorous 10-factor style isolation process to objectively segregate companies into their appropriate investment style and size universe.
The CBOE S&P 500 Implied Correlation Index measures the expected average correlation of price returns of S&P 500 Index components, implied through S&P 500 Index option prices and prices of single-stock options for the 50-largest largest components of the S&P 500 Index.
Senior Equity Product Strategist
Nick Kalivas is a Senior Equity Product Strategist representing Invesco’s exchange-traded funds (ETFs). In this role, Mr. Kalivas works on researching, developing product-specific strategies and creating thought leadership to position and promote the smart beta equity lineup.
Prior to joining Invesco, Mr. Kalivas spent the majority of his career in the futures industry, delivering research, strategy and market intelligence to institutional and high net worth clients centered in the equity and interest rate markets. He was a featured contributor for the Chicago Mercantile Exchange, and provided research services to a New York-based global macro commodity trading advisor where he supplied insight on equities, fixed income, foreign exchange and commodities. Nick has been quoted in the Wall Street Journal, Financial Times, Reuters, New York Times and by the Associated Press, and has made numerous appearances on CNBC and Bloomberg.
Mr. Kalivas has a BBA in accounting and finance from the University of Wisconsin – Madison and an MBA from the University of Chicago Booth School of Business with concentrations in economics, finance, and statistics. He holds the Series 7 and Series 63 registrations.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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