PMC Weekly Review - January 19, 2018

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.

Download the full PDF

Note: Factor performance provided by Envestnet | PMC Quantitative Research Group (QRG). All other performance statistics provided by Bloomberg.

The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this weekly review is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. The asset classes and/or investment strategies described may not be suitable for all investors and investors should consult with an investment advisor to determine the appropriate investment strategy. Past performance is not indicative of future results.

Information obtained from third party sources are believed to be reliable but not guaranteed. Envestnet|PMC™ makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.

Investments in smaller companies carry greater risk than is customarily associated with larger companies for various reasons such as volatility of earnings and prospects, higher failure rates, and limited markets, product lines or financial resources. Investing overseas involves special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. Income (bond) securities are subject to interest rate risk, which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates. Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to its direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. ETFs may trade at a discount to their net asset value and are subject to the market fluctuations of their underlying investments. Investing in commodities can be volatile and can suffer from periods of prolonged decline in value and may not be suitable for all investors. Index Performance is presented for illustrative purposes only and does not represent the performance of any specific investment product or portfolio. An investment cannot be made directly into an index.

Alternative Investments may have complex terms and features that are not easily understood and are not suitable for all investors. You should conduct your own due diligence to ensure you understand the features of the product before investing. Alternative investment strategies may employ a variety of hedging techniques and non-traditional instruments such as inverse and leveraged products. Certain hedging techniques include matched combinations that neutralize or offset individual risks such as merger arbitrage, long/short equity, convertible bond arbitrage and fixed-income arbitrage. Leveraged products are those that employ financial derivatives and debt to try to achieve a multiple (for example two or three times) of the return or inverse return of a stated index or benchmark over the course of a single day. Inverse products utilize short selling, derivatives trading, and other leveraged investment techniques, such as futures trading to achieve their objectives, mainly to track the inverse of their benchmarks. As with all investments, there is no assurance that any investment strategies will achieve their objectives or protect against losses.

Neither Envestnet, Envestnet|PMC™ nor its representatives render tax, accounting or legal advice. Any tax statements contained herein are not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. Taxpayers should always seek advice based on their own particular circumstances from an independent tax advisor.

© 2018 Envestnet. All rights reserved.