A recently released Greenwich Associates study identified 3 primary investor concerns heading into 2019:
1) the economy may enter a recession (63%),
2) interest rates will rise/credit will become scarce (63%), and
3) volatility will adversely impact portfolios (54%).
While the survey focused on institutions, we see investors of all types making changes to their portfolios to position for resilience. These changes, imply that investors believe they can shift their portfolio allocations around the economic cycle and maximize investment outcomes. In fact, we believe this as well. We would propose that investors, if equipped with the right tools, proper data, and a disciplined investment strategy, may have a greater opportunity to outperform the broader market over time by dynamically shifting allocations in their portfolios. The million dollar question then turns to: “how?”
Sector Rotation – Familiar but troublesome
One of the most popular and familiar portfolio positioning strategies aimed at enhancing return has been sector rotation. These strategies time or tilt to sectors based on economic views and expected sector performance.
For example, in a typical economic contraction, business demand and consumer confidence decline leading to decreased corporate profits, higher unemployment, and reduced consumer spending and capital investment. In this uncertain environment, individuals may forego purchasing a luxury car (such as a shiny red Ferrari!) but will most likely continue to purchase food or pay their electric bill. From an investment standpoint, investors might tilt towards defensive sectors such as consumer staples, utilities and health care as there will still be continued demand for those products and services despite the economic contraction. Similarly, investors may choose to be underweight those sectors that display more cyclical characteristics such as financials, technology and consumer discretionary, which are more dependent on underlying economic growth and consumer spending.
While sector tilting or sector rotation strategies, in theory, are built on economic foundations, they overlook some critical properties that could be detrimental to investors. Despite being familiar, sectors merely proxy a desired exposure; they are not proven long-term drivers of return. For example, technology, should provide exposure to firms that do well in periods of economic growth. Health care, should provide exposure to firms that will better weather an economic downturn. However, individual company characteristics, not sector classifications, are what will ultimately drive performance.
Some investors might argue that companies within the same sector have similar characteristics. While this is broadly true (classifications do group companies with similar business lines, after all!), we would propose that if you look under the hood, many sectors are in fact far more diverse than you might think. The health care sector is a great example. While the overall sector may serve as a decent proxy for a defensive exposure, the characteristics of individual companies within the sector differ. These differences are observable through the performance of the various industries within the sector. We find that investors looking to sectors to achieve an outcome, such as a defensive posture, might find them to be a blunt instrument, containing stocks working against the desired result.
Factor Rotation: A Potential Solution
So if investors are really after defensive exposure, wouldn’t it make more sense to invest directly in companies with defensive characteristics (stable business models, consistent earnings, and lower risk than the market), rather than try to proxy this exposure through a sector, which selects stocks simply by their broad industry categorization? If only there were an efficient, simple way to directly access this exposure through companies with known defensive characteristics!
Oh wait, there is!
These desired defensive exposures can be directly captured through factor strategies. Quality Factor investing by design, invests directly in companies that exhibit strong balance sheets and more stable earnings, and Minimum Volatility strategies are built to provide a defensive portfolio of stocks. Similarly, investors can more directly attempt to outperform in a rapidly expanding economy by focusing on factor strategies positioned to do well in a booming economy, such as Value and Size. Put simply, factors can be a more precise way to pursue out-performance based on economic shifts.
Even though we believe factors allow for a more precise and intuitive way to achieve desired exposure, we are still left with the question of investor ability. Accurately identifying where we are in the economic cycle is quite difficult even for the most experienced investor. For one, economic cycles do not often follow a smooth pattern like the visual depictions in economics classes often suggest. Thus, investors may be better served relying not only on expert active management to time economic regimes, but also a model that considers other elements such as factor valuations, dispersion or relative strength, as a way to inform when to tilt towards one factor vs another. This is an approach BlackRock has explored, implemented and tracked, and is now bringing to market to give investors access to factor tilting. And for those investors who still prefer to invest by themselves, we believe that factors such as quality and minimum volatility can be a far more intuitive way to capture investment sentiment as we continue to weather market uncertainty.
Holly Framsted, CFA, is the Head of US Factor ETFs within BlackRock’s ETF and Index Investment Group and is a regular contributor to The Blog. Elizabeth Turner, Vice President and Christopher Carrano, Associate are members of the Factor ETF team and contributed to this post.