As the economy and markets mature, stock investors should consider tactical smart beta factor exchange traded fund investments to optimize a portfolio for the environment ahead.
“With U.S. unemployment at nearly “full” status and inflation starting to pick up in spots, the Federal Open Market Committee (FOMC) recently decided to hike rates for the third time this year, and in the process alluded to the possibility of three more rate hikes in 2018,” Dave Mazza, SVP of Beta Solutions at OppenheimerFunds, said in a research note. “A study of factor performance during rising rate environments reveals that, historically, these periods tend to reward the Size and Value factors, while the Low Volatility and Yield factors often suffer.”
When looking at the performance of factor indices over the eight separate time periods when U>S. interest rates increased by more than 100 basis points, two dominant trends stood out: investors rewarded small companies and those with attractive valuation multiples relative to current prices.
The Russell 1000 Size Factor Index and Russell 1000 Value Factor Index averaged 4.7% and 2.3% in excess returns over the Russell 1000 benchmark, respectively. Since rising interest rates typically coincide with increases in inflation and GDP growth, the potential for continued improvements in economic growth can give investors greater confidence to take on more risk in the stock market, with pro-cyclical factors being rewarded.
On the other hand, low volatility and higher dividend yield-oriented stocks consistently underperformed when rates rise. Since yield-generating companies typically use internally generated cash flow to pay dividends and rely on debt issuance to finance new projects, the rising borrowing costs from rate hikes negatively impact these companies more quickly, and investors tend to punish their shares accordingly.
Meanwhile, low-vol stocks underperform their benchmark as well as the average investor look to take on more portfolio risk in response to positive GDP growth and inflation, so investors would avoid conservative companies that historically exhibited stable payouts.
Investors interested in the size and value factors may consider targeted smart beta ETF plays, such as the Oppenheimer Russell 1000 Size Factor ETF (Cboe: OSIZ) and Oppenheimer Russell 1000 Value Factor ETF (Cboe: OVLU). OSIZ follows companies in the Russell 1000 Index with smaller market capitalizations than the broader U.S. equity market. OVLU tracks companies in the Russell 1000 Index that exhibit lower valuations relative to the broader U.S. equity market.
OppenheimerFunds also offers a suite of revenue-weighted ETFs that specifically focus on companies with high revenues, including the Oppenheimer Large Cap Revenue ETF (NYSEArca: RWL), Oppenheimer Mid Cap Revenue ETF (NYSEArca: RWK), Oppenheimer Small Cap Revenue ETF (NYSEArca: RWJ), Oppenheimer Ultra Dividend Revenue ETF (NYSEArca: RDIV), Oppenheimer Financials Sector Revenue ETF (NYSEArca: RWW), Oppenheimer ESG Revenue ETF (NYSEArca: ESGL) and Oppenheimer Global ESG Revenue ETF (NYSEArca: ESGF).
For more on smart beta ETFs, visit our Smart Beta Channel.