Which factors topped the list in the second quarter of 2017?

Growth and momentum strategies continue their comeback stories

Which factors topped the list in the second quarter of 2017?

Nick Kalivas

Growth and momentum again topped factor performance in the second quarter of 2017, with smaller-cap versions of both factors outpacing their large-cap counterparts. Growth stocks were in such favor during the quarter that the Russell 2000 Pure Growth Index and Russell MidCap Pure Growth Index were the two best performers, despite the fact that small- and mid-cap stocks as a whole lagged the broader market, as represented by the S&P 500 Index.

Factor leadership can vary from quarter to quarter, depending on market conditions and economic trends. Growth began its comeback in the first quarter of 2017 as the outlook for robust fiscal stimulus, in the form of tax cuts and infrastructure spending, faded. The small- and mid-cap value, dividend and high beta factors lagged during this time — weighed down by weakness in commodity prices and diminishing growth prospects.

More factors outperformed the broad market this quarter, with 12 factor indexes outpacing the S&P 500 Index, compared with just four last quarter. However, a wide dispersion in returns was again evident, including a 10.56% difference in return between the best-performing (small-cap growth) and worst-performing (mid-cap value) factor indices.

S&P 500 Index returns dominated by mega-cap technology and health care stalwarts

The S&P 500 Index showed significant concentration during the second quarter, with returns driven by a small number of technology and health care names. In fact, just 10 stocks (counting Alphabet Class A and Class C shares as the same company), accounted for nearly 40% of the S&P 500’s return. Alphabet, Amazon, Microsoft, Johnson & Johnson and United Healthcare were the strongest contributors; all have growth characteristics from a factor perspective. Investor enthusiasm about cloud computing and plays on technology disruption were also helpndl to growth stocks outside of the health care sector.

Macro conditions supported growth, momentum and small-cap stocks, but worked against the value factor. A relative lack of market stress also created headwinds for low volatility, quality and dividend strategies.

Factor performance: Q2 2017 vs. Q1 2017 (Second quarter vs. first quarter)

Factor performance

Source: Bloomberg L.P., June 30, 2017. Past performance is no guarantee of future results. Index returns do not represent fund returns. An investor cannot invest directly in an index.

Sanguine backdrop helps small caps and momentum, hurts low volatility and quality

Indicative of a low-risk market environment, both high-yield spreads and VIX — a barometer of near-term volatility —contracted and remained at relatively low levels during the quarter. This provided a supportive backdrop for small-cap shares, which have historically thrived in a lower-risk climate. The muted risk environment also led investors to hold onto their higher-performing stocks rather than selling to lock in gains, which benefited the momentum factor. Conversely, the lack of volatility and credit stress constrained low volatility and quality performance.

helps small caps and momentum, hurts low volatility and quality

Source: Bloomberg L.P., June 30, 2017. Commodity prices High-yield spreads are defined by the Bloomberg Barclays U.S. Corporate High Yield Yield-to-Worst – 10-Year Treasury Spread Index. The CRB BLS Spot Index is made up of prices on hides, tallow, copper scrap, lead scrap, steel scrap, zinc, tin, burlap, cotton, print cloth, wool tops, resin and rubber.

During the second quarter, the 10-year Treasury yield fell nine basis points and yields remained historically low. This rate dynamic was a drag on the value factor, but provided marginal support to low volatility shares.

Soft economic backdrop, weak US dollar

The economic picture was mixed to soft during the second quarter. Although the Institute for Supply Management (ISM) manufacturing survey rose 0.6 points to 57.8,1 commodity prices were weak. In addition, the Citigroup Economic Surprise Index plunged,2 indicating that economic conditions were much more sluggish than economists had predicted. On balance, the growth picture held back the value factor and supported low volatility and growth stocks, which tend to outperform in slower economic environments.

The dollar weakened during the quarter. A weak dollar makes US exports cheaper abroad, and might normally boost the outlook for inflation and economic growth during other periods, which would have benefited value shares. But weakness in commodity prices, coupled with surprise about how economic data failed to meet expectations, provided an offsetting effect in the second quarter.

Looking ahead

At the end of the quarter, the outlook for the value factor brightened. The US Federal Reserve (Fed) blessed the strong capital return programs proposed by banks, and European Central Bank (ECB) President Mario Draghi highlighted signs that the eurozone economy was reflating in the wake of a historically high German ifo survey.3 Moreover, concerns about valuations expressed by Federal Reserve Chair Janet Yellen, Vice Chairman Stanley Fischer and Federal Reserve Bank of San Francisco President John Williams put a spotlight on less-expensive stocks.4

Many banks are looking like value plays, given their low valuation characteristics and potential drivers of return. The end of ECB quantitative easing has lifted expectations for higher interest rates and a steeper yield curve, in my view — two macro dynamics that can benefit financial stocks. Furthermore, investors may also have locked in profits on growth stocks, given their strong relative performance in 2017 and the Fed’s recent rhetoric.

I believe there is a chance that economic expectations will improve over the coming year. The Citigroup Economic Surprise Index is depressed and is currently closer to the bottom than the top of its historical range. It is possible that economists have lowered the bar, making it easier for economic numbers to surprise to the upside — potentially improving the prospects for economic growth, higher interest rates and value shares. There is also the possibility that President Donald Trump’s economic agenda, which has stalled, picks up some momentum after the summer recess.

Technically, the S&P 500 Enhanced Value Index has shown signs of breaking out of its downtrend against the S&P 500 Index. The chart below shows the price ratio of the S&P Enhanced Value Index to the S&P 500 Index. In my view, this may bode well for improved value factor performance.

S&P Enhanced Value Index to the S&P 500 Index.

Source: Bloomberg L.P., June 30, 2017

Given ongoing tensions in the Middle East, chilly US relations with China, North Korea’s march toward nuclear weapon capabilities and the political policy circus in Washington, D.C., low volatility and value could be compelling solutions for mitigating risk and navigating today’s complicated geopolitical backdrop.

Investors looking for value and low volatility solutions may want to explore the PowerShares S&P 500 Enhanced Value Portfolio (SPVU), and PowerShares S&P 500 Low Volatility Portfolio (SPLV).

Allocations as of July 12, 2017: PowerShares S&P 500 Low Volatility Portfolio – Amazon: 0.00%, Microsoft: 0.91%, UnitedHealth Group: 0.99%, Johnson & Johnson: 1.35%, Alphabet, Inc.: 1.96%. PowerShares S&P 500 Enhanced Value Factor Portfolio – Amazon: 0.00%, Microsoft: 0.00%, UnitedHealth Group: 0.00%, Johnson & Johnson: 0.00%. Holdings mentioned are for informational purposes only and are not buy or sell recommendations.

1 Source: Institute for Supply Management, May 22, 2017

2 Source: Yardeni Research, Inc., July 7, 2017

3 Source: CESifo, GmbH, June 2017

4 Source: Bloomberg Markets, June 27, 2017

Important information

Blog header image: Beneda Miroslav/Shutterstock.com

A price ratio compares the price of one security (or basket or securities) to another security (or basket of securities). In this case, the prices of two indexes are compared.

Factor investing is an investment strategy in which securities are chosen based on certain characteristics and attributes.

Commodities and futures generally are volatile and are not suitable for all investors.

There is no guarantee that low-volatility stocks or ETFs will provide low volatility.

Investing in securities of large-cap companies may involve less risk than is customarily associated with investing in stocks of smaller companies.

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.

Momentum style of investing is subject to the risk that the securities may be more volatile than the market as a whole, or that the returns on securities that have previously exhibited price momentum are less than the returns on other styles of investing.

Growth stocks tend to be more sensitive to changes in their earnings and can be more volatile.

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.

Treasury securities are backed by the full faith and credit of the US government as to the timely payment of principal and interest.

Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.

An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.

The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

There are risks involved with investing in ETFs, including possible loss of money. Index-based ETFs are not actively managed. Actively managed ETFs do not necessarily seek to replicate the performance of a specified index. Both index-based and actively managed ETFs are subject to risks similar to stocks, including those related to short selling and margin maintenance. Ordinary brokerage commissions apply. The fund’s return may not match the return of the Index.

Investments focused in a particular industry or sector are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.

The funds are non-diversified and may experience greater volatility than a more diversified investment.

Shares are not individually redeemable, and owners of the shares may acquire those shares from the fund and tender those shares for redemption to the fund in creation unit aggregations only, typically consisting of 10,000, 50,000, 75,000, 100,000 or 200,000 shares.

A basis point is a unit that is equal to one one-hundredth of a percent.

Spread represents the difference between the yield on a corporate bond and a similar maturity US Treasury bond.

Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time.

The Bloomberg Barclays US Corporate High Yield to Worst―10-Year Treasury Spread Index, which displays the yield spread between a portfolio of high yield notes as defined by Barclays Capital and the 10-year Treasury yield, measures risk in the high yield market.

The CBOE Volatility Index (VIX) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility.

The Citigroup Economic Surprise indexes are quantitative measures of economic news, defined as weighted historical standard deviations of data surprises; a positive reading of the Economic Surprise Index suggests that economic releases have on balance been beating consensus estimates.

The CRB BLS Spot Index measures price movements of 22 sensitive basic commodities from markets presumed to be among the first to be influenced by changes in economic conditions.

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 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 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 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 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 Dynamic Market Intellidex Index seeks to identify and select companies from the US marketplace with superior risk-return profiles.

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 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 ifo Business Climate Index is a highly-regarded early indicator of economic developments in Germany published on a monthly basis.

The ISM Manufacturing Index, which is based on Institute of Supply Management surveys of more than 300 manufacturing firms, monitors employment, production inventories, new orders and supplier deliveries.

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 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 Russell 1000 Equal Weight Index captures the risk and return performance of an equal weight investment strategy for US large-cap stocks.

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 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 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 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 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 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 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 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 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 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 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 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 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 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 MidCap 400 Index is an unmanaged index considered representative of mid-sized US companies.

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 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 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 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 US Dollar Index measures the value of the US dollar relative to majority of its most significant trading partners. The Global Industry Classification Standard was developed by and is the exclusive property and service mark of MSCI, Inc. and Standard & Poor’s.

Nick Kalivas

Senior Equity Product Strategist

PowerShares by Invesco

Nick Kalivas is a Senior Equity Product Strategist representing the PowerShares family of exchange-traded funds (ETFs). In this role, Nick works on researching, developing product-specific strategies and creating thought leadership to position and promote the smart beta* equity line up.

Prior to joining Invesco PowerShares, 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.

Nick 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.

*Beta is a measure of risk representing how a security is expected to respond to general market movements. Smart beta represents an alternative and selection index based methodology that may outperform a benchmark or reduce portfolio risk, or both.

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