Examining factor performance during a year of concentrated gains

Market trends sparked big wins for growth and momentum in 2017

Examining factor performance during a year of concentrated gains

Nick KalivasTime to read: 3 min

The books are closed for 2017. It was another strong year for the equity market, with the S&P 500 Index up 21.8%. Performance was highly concentrated, with more than one-third of the S&P 500’s gains linked to technology stocks and roughly 15% of the gains coming from the financials sector. Health care came in a close third to financials, representing 14.2% of the S&P 500’s total return. Together, these three sectors accounted for more than two-thirds of the S&P 500’s gains. Conversely, energy and telecommunication services were the only two sectors with negative performance. The table below highlights each sector’s contribution to the total return of the S&P 500 Index in 2017.

2017 returns by sector

2017 returns by sector

Source: Bloomberg L.P. as of Dec. 31, 2017. Past performance is not a guarantee of future results.

Gains were also concentrated by company. In fact, Apple, Microsoft, Facebook, Alphabet (via two share classes) and Amazon accounted for nearly one-fourth of the total return generated by the S&P 500 Index. Factoring in JP Morgan, Bank of America, Visa, Johnson & Johnson and Home Depot, just 10 companies accounted for nearly one-third of the S&P 500’s one-year gain.

Most of the companies highlighted above are growth names. As financial stocks, JP Morgan and Bank of America are more value-oriented in nature, but are also included in the S&P 500 Momentum Index. There is no rule that says factor exposure must be exclusive. The same stock can possess multiple factor characteristics. The concept is called overlap. Currently, the overlap between the S&P 500 Momentum Index and the S&P 500 Enhanced Value Index is about 30%.

Growth and momentum factors outperformed in 2017

Factor performance was varied in 2017, with growth and momentum ending the year as the best-performing factors. Examining 31 factor-based indices (including market-cap-weighted and broad-market indexes as factors), mid-cap growth was the strongest performer, followed closely by large-cap momentum. Large- and mid-cap momentum stocks outpaced the S&P 500 Index, while small-cap growth and momentum shares outperformed the S&P SmallCap 600 Index.

There was again wide factor dispersion in 2017, with a roughly 35% performance spread between the best-performing (mid-cap growth) and worst-performing (small-cap high dividend/low volatility) factors. This dispersion underscores the fact that factors provide differentiated risk and return profiles relative to market-cap-weighted indices.

Factor returns sorted by 2017 performance

Factor returns by 2017 performance

Source: Bloomberg L.P. as of Dec. 31, 2017. Past performance is not a guarantee of future results. An investment cannot be made into an index.

Macroeconomic environment key to factor performance

Macroeconomic factors helped explain the strength of the growth and momentum factors. Equity volatility and credit spreads continued to fall, while the correlation between stocks finished the year down sharply. A limited risk environment also allowed momentum to thrive, with 10-year Treasury yields stable and commodity prices up only modestly.

Given muted commodity inflation and low interest rates, the reflation trade diminished as the year progressed. Despite strength in the Purchasing Managers Index and strong corporate earnings, benign commodity prices and low 10-year Treasury yields created headwinds to value and smaller-size shares, allowing the growth and momentum factors to outperform. In addition, the lack of headway on tax reform early in 2017 kept a check on small size and value, which had rallied following the election of President Donald Trump. From a sector perspective, small-cap information technology and financials also performed sluggishly in the fourth quarter, lacking the impact seen in their large-cap counterparts.

Drivers of return

Source: Bloomberg, L.P. as of Dec. 31, 2017. Commodity prices represented by the CRB BLS Spot Index. High yield spreads represented by the Barcap US Corporate High Yield to Worst – 10 year Treasury Spread Index.

Anticipation of tax reform paced fourth-quarter returns

The prospect of federal tax reform helped boost large-cap value and high beta stocks in the fourth quarter, which outpaced the S&P 500 Index by 1.40% and 1.29%, respectively. But these factors could not keep pace with the mid-cap growth and large-cap momentum factors, which were the strongest performers during this time. Value and high beta stocks were also aided by a rally in financials, which were viewed as likely beneficiaries of tax reform. Financials comprised more than one-third of the return generated by the S&P 500 Momentum Index and were nearly as important as information technology to performance contribution.

Important information

Blog header image: taffpixture/Shutterstock.com

Correlation is the degree to which two securities or investments have historically moved in relation to each other.

Earnings per share (EPS) refers to a company’s total earnings divided by the number of outstanding shares.

The inventory-to-sales ratio depicts the relationship between a company’s end-of-month inventory values and monthly sales.

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 reflation trade refers to the practice of investors looking to buy value and cyclical stocks in an effort to benefit from periods of strengthening economic growth, rising inflationary pressures and increasing interest rates.

The Barcap 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 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.

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 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 Purchasing Managers Index (PMI), a commonly cited indictor of the manufacturing sector’s economic health, is calculated by the Institute of Supply Management.

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. 

About risk

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

In general, equity values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

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

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

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.

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

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.

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

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.

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.

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