ETF factor analysis: value, quality rule; The momentum is fading
As we end the first quarter of 2021, we are witnessing a clear changing of the guard. While 2019 and 2020 were dominated by large caps and growth stocks, 2021 saw a resurrection for small caps and value stocks. The COVID pandemic has also led investors to seek safer alternatives instead of seeking growth at all costs.
After lagging behind for several years, value stocks are finally making a comeback. Value stocks, in general, tend to outperform during periods of recovery, but overweightings in energy and financial stocks are particularly useful. After the April oil crash that occurred in response to COVID shutdowns, oil prices have fully recovered and now reflect the surge in energy demand expected for the end of the year. Interest rates have also increased significantly, which has improved the chances for banks to lend profitably.
Small caps have also been on the rise in recent times, also betting on an economic rebound and billions of dollars in stimulus and loan packages designed to help small businesses survive the recession. As long as the recovery rhetoric remains intact, the trend towards value / small cap outperformance could continue, although a weak job market and over-reliance on central bank intervention could potentially cause problems.
Looking at ETF factor returns in 2021, we can clearly see these trends manifesting themselves.
Value was the big winner, returning almost 20% in the first quarter alone. The outperformance of small caps can be seen in the size factor ETF, which is up over 9% since the start of the year.
Another incidental beneficiary of this pivot has been the quality factor. The sudden COVID bear market of 2020, which disproportionately impacted companies with poor balance sheets and high debt, has prompted investors to seek stocks backed by healthier cash flows and more stable earnings. This led to comparatively above-average yields in 2021, but the quality has also been a good underhand performance over the past three years.
The surprise on this list could be the momentum factor. For a while, this was the only factor beating the market with its overweight in technology and growth stocks. This tilt, however, worked against it in 2021. This ETF is still invested almost 3/4 in the combination of the tech, communications services and consumer discretionary sectors. As the market has recently favored cyclical and value stocks (and given the fund’s infrequent rebalancing schedule), this overexposure has been an anchor and easily led it to be the worst performer.
When it comes to ETF flows, investors haven’t completely given up on dynamic stocks, but the latest market trends have manifested themselves in the places where investors put their money.
Low volatility stocks have seen huge capital outflows, with investors betting heavily on recovery games. Value is the one factor that ETF investors have bet heavily on this year. Quality saw outflows of $ 3 billion in 2021. Even the size factor has seen outflows despite its strong returns recently.
Since investor activity tends to follow performance, I would expect value to continue to attract dollars. I think small caps could catch up, although other small cap ETFs are seeing relatively lukewarm interest as well. If the last race did not generate much interest, it may be a while before it generates more interest.
Momentum will be the one to watch. The ETF is only rebalanced twice a year in May and November. It will maintain its tech / growth slant for at least another month, so performance will depend on whether cyclicals are maintained or not. Once the rebalance date has passed, it may seem more strongly biased towards cyclicals and value, but it could be an underperforming performance so far.
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