A Macro View: The X Factors of 2017
Envestnet | PMC’s research department is dedicated to finding the best money managers on the planet—the ones that will outperform on a go-forward basis over the next full market cycle. However, we have no illusions that outperformance will occur every month, quarter, or year. Even the very best managers may experience short periods—and sometimes years—of underperformance throughout a full market cycle.
So aside from stock selection, why do managers outperform or underperform their respective benchmarks? Factor biases have a lot to do with it, and nearly every active manager has them. Although factor-based investing (often referred to as smart beta) is a more recent phenomenon, active managers have generally had factor biases and factor tilts—intentional or not—that affect portfolio performance. PMC invests in a few factors (i.e., size, momentum, and quality) via our Quantitative Portfolios, but we examine many more when evaluating the performance of active managers on our platform.
With 2017 in our rearview mirror, now is a good time to look back at how the various factors performed over the course of the year. That provides us with a helpful lens when evaluating the performance of the various managers on our platform.
As we all know, the global equity markets in 2017 experienced strong, steady growth across the board. Many asset classes yielded total returns in excess of 20% with relatively low volatility. Many investors made a lot of money.
From a factor standpoint, we saw risk-on segments of the market rewarded in many instances, which is consistent with what we’d expect during a period of strong growth and high returns. Perhaps one of the most influential factors throughout 2017 was growth vs. value. Growth outperformed value by at least 10% across the market cap spectrum. Similarly, low-dividend yielding stocks outperformed high-dividend payers both domestically and abroad. Momentum was another big winner.
However, not all risk-on bets paid off over the course of the year. The size factor actually yielded risk-off results, as large caps outperformed small caps across the board (with the exception of the international developed markets space). Stocks with high return on equity also outpaced stocks with low return on equity in most cases, another example of a risk-off winner.
Although the performance of these key factors is interesting to note, interpreting them and comparing these results with mutual fund or separately managed account (SMA) performance is the critical component. If an emerging markets manager underperformed by 500 basis points in 2017 (still not a bad haul, given that the Russell Emerging Markets Index was up 36.77%), consider the factor headwinds and tailwinds that contributed to that underperformance before kicking them to the curb. If an emerging markets manager had low beta and small cap biases, maybe 500 basis points of underperformance wasn’t so bad, considering that in calendar year 2017, the top 40% of emerging markets stocks measured by beta outperformed the bottom 40% by 17.19%, and the top 40% of those stocks measured by market cap outperformed the bottom 40% by 21.65%. Viewed from this prospective, and considering the factor headwinds, the manager must have done a great job of stock selection just to achieve that 500 basis points of outperformance.
Now that 2018 is underway, we may not be able to predict which factors will be winners this year, nor which ones will be losers, but we can set some expectations depending upon how the markets perform. If stocks continue to march higher, the momentum and high beta stocks are likely to continue their run of outperformance. If we see a downturn in 2018, the value factor is likely to come back into favor relative to growth.
And whatever happens, remember to evaluate portfolio performance against these various factors, rather than merely looking at absolute returns or benchmark-relative returns. The devil is in the details.
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Note: Factor performance provided by Envestnet | PMC Quantitative Research Group (QRG). All other performance statistics provided by Bloomberg.
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