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Summary Dividend and low volatility factors were the clear winners in the third quarter of 2015, while small-cap, high beta and value factors lagged. Exposure to in-favor consumer discretionary and sectors aided momentum and growth factors throughout much of 2015. Although factors have been shown to outperform the broad market over long periods, they can either underperform or outperform over the short term due to market and economic conditions. High beta, small-cap momentum factors struggle amid corporate earnings concerns By Nick Kalivas In my previous blog, I discussed sector performance thus far in 2015. Here, I’d like to examine the performance of US equities via different investment styles, or “factors,” as they’re known in the world of smart beta investing. Third quarter marked by heightened volatility Factor returns in the third quarter were materially influenced by a correction in equities, which began in earnest after the July 20 market highs. This selloff was sparked in part by the deflation of the Chinese stock market bubble, which generated concerns over global economic growth and prompted many companies to lower their earnings guidance. Corporate profit estimates had already been under pressure through much of 2015 due to the lagged impact of a strong dollar, a drop in commodity prices and inventory overhang. Once earnings estimates were revised, credit spreads widened and market volatility escalated – affecting factor performance. Despite largely negative returns, there was tremendous factor dispersion in the third quarter, with a spread of nearly 15% between the best performing factors – dividend and low volatility, and the worst-performing factor – high beta. Although research has shown that many factors have historically outperformed the broad market across market cycles, the third quarter demonstrated that factors are not immune from short-term volatility. Factor returns – Q3 and YTD 2015 Source: Bloomberg L.P., Sept. 30, 2015. Past performance is no guarantee of future results. An investment cannot be made directly into an index. Factor performance: The good Among the best performing factors in the third quarter of 2015: Dividend growth. Dividend growth, as measured by the NASDAQ Dividend Achievers 50 Index, outperformed the S&P 500 Index by 3.53%. Low volatility. The large-cap S&P 500 Low Volatility Index outpaced the S&P 500 Index by 5.26%, while the S&P MidCap 400 Low Volatility Index outperformed the S&P MidCap 400 Index by 6.62%. A combination of dividend growth and low volatility. This multi-factor strategy, as defined by the S&P 500 Low Volatility High Dividend Index, generated a positive return of 0.36%, besting the S&P 500 Index by 6.80%. Quality. As defined by the S&P 500 High Quality Rankings Index, quality outperformed the broader large-cap market by 2.79%. Also note that large-cap growth stocks outpaced the S&P 500 Index by 2.28%, while large-to-mid-cap momentum stocks lagged the S&P 500 Index by just 0.16%. Both factors benefited from their exposure to the consumer discretionary and health care sectors, which displayed relatively strong earnings growth. Factor performance: The bad Large-cap value strategies, as defined by the Dynamic Large Cap Value Indellidex Index and NASDAQ Buyback Achievers Index, underperformed the S&P 500 Index by 90 to 301 basis points (0.90% to 3.01%) during the third quarter respectively. Within the value universe, buyback – a factor focusing on companies that have shown a propensity to buy back outstanding shares – was the worst performer during the quarter, while fundamental (FTSE RAFI US 1000) fared better. As a whole, value stocks were pressured by low interest rates and the cyclical slowdown in economic growth. Although value stocks often trade below their intrinsic values, they can be influenced by economic cycles and interest rates. Many value names in the financial sector fell victim to cyclical weakness during the third quarter, as evidenced by the deceleration in the Institute for Supply Management’s manufacturing index, which declined from 53.2 in June to 50.2 in September. 2 Factor performance: The ugly The worst performing factors were high beta – comprising stocks sensitive to market movements – small-cap momentum and mid-and-small-cap fundamental. The S&P 500 High Beta Index dropped 14.72% during the third quarter, while the two small-cap indexes were off by more than 10%. Concerns over an inventory correction among technology providers, continued stress in the energy sector and a dimmed profit outlook for industrials sector weighed on high beta names. Generally speaking, small-cap stocks were hurt by increased volatility, a flight to quality and rising credit spreads, although small-cap low-volatility shares fared much better. The performance of small-cap shares can be inversely related to market stress. One of the theories explaining long-term small-cap outperformance rests in investors being compensated for the added risk of owning smaller companies. In periods of risk aversion, however, buyers step away – depressing small-cap stock prices and offering buyers the potential to realize outsized future returns in exchange for taking on more risk. A second theory supporting small-cap returns is rooted in the idea that small companies grow faster than large companies and the general economy. A diminished earnings growth outlook called into questioned the vibrancy of small-cap earnings. Looking ahead Although the fourth quarter is still young, high beta stocks have shown signs of rebounding, buoyed by a recovery in cyclical and commodity shares. Contrarian investors expecting revived aggregate demand might wish to consider small cap, high beta, and value strategies, which have been out of favor for most of 2015. Conversely, those who anticipate ongoing market turbulence may want to evaluate their allocations to low volatility and quality stocks. Of course, please speak with your financial adviser before making any investment decisions. Invesco PowerShares offers a broad lineup of exchange-traded funds that track factor-based indexes. Two that were just launched this month are the PowerShares S&P 500 Value Portfolio (NYSEARCA: SPVU ) and PowerShares S&P 500 Momentum Portfolio (NYSEARCA: SPMO ). For more on factor investing, visit our Factor Investing page. 1 Bloomberg, L.P., Sept. 30, 2015 2 Institute for Supply Management, Oct. 1, 2015 See here for important disclosure information. Scalper1 News
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