The fourth quarter of 2018 was exceedingly tough for US equities, with no gains to be found in any of the indexes tracked by our quarterly factor scorecard. And yet, certain factors — namely Low Volatility and Dividend Yield — were able to significantly cushion the blow suffered by the broad market. While the S&P 500 Index lost 13.52% in the quarter, the S&P 500 Low Volatility Index fell just 5.22%, and the S&P 500 Low Volatility High Dividend Index fell just 6.77%.
These two factors outperformed in the small-cap space as well, which was the hardest-hit in the quarter. While the S&P SmallCap 600 Index lost 20.10% in the quarter, the S&P SmallCap 600 Low Volatility Index fell just 12.64%, and the S&P SmallCap 600 Low Volatility High Dividend Index fell just 13.92%.
The world is always clear in retrospect, but exposures to the Low Volatility and Dividend Yield factors would have helped to soften the blow of the fourth quarter sell-off. In my view, this reinforces the usefulness of factor strategies designed to help mitigate risk. All told, there were 14 equity factor indexes that outpaced the S&P 500 in the fourth quarter, and 11 for all of 2018.
Low volatility and dividend factors were supported by a 65.7% rise in the VIX Index, which jumped from 12.12 to 25.42 during the fourth quarter. Likewise, high yield spreads (as defined by the Barcap US Corporate High Yield to Worst -10 Year Treasury Spread Index) surged 109.7%, widening from 3.18% to 5.27%. The flaring of risk was also a drag on the small-cap sector.
The lagged impact of monetary tightening and a flatter yield curve, coupled with slower profit growth, are expected to keep equity volatility elevated in 2019. I believe this has the potential to support the Low Volatility and Dividend Yield factors.
According to Standard & Poor’s as of Dec. 31, 2018, S&P 500 earnings are expected to rise 9.4% in 2019 compared to 26.1% in 2018. In a slowing growth environment, companies with strong balance sheets and financial health — which are included in the Quality factor — have tended to provide an attractive option for investors looking to take more risk than offered by the Low Volatility and Dividend Yield factors.
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, in my view. Some of these factors include growth and high beta, for example.