The WisdomTree Q2 2022 Asset Class and Risk Factor Review and Outlook
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Regular readers of WisdomTree blogs know that we are firm believers in both asset class and risk factor diversification when building our Model Portfolios. We believe this increases the potential for more consistent performance over full market cycles. This goes together with our belief in the power of compounding—if you don’t lose as much in down markets, you don’t have to win as much in up markets to still come out ahead in the long run.
Equity Asset Class Review and Outlook
Let’s begin with a quick Q1 review of asset class performances. Geographically, the U.S. outperformed the EAFE and emerging markets (“EM”) regions, at least partially due to a consistent strengthening of the dollar, but with respect to the EM, mostly due to the ongoing economic and market slump in China.
For definitions of the terms in the chart above, please visit the glossary.
EAFE small caps underperformed EAFE large caps for the quarter, but a longer time horizon “lens” illustrates why we like that asset class as a strategic holding in our Model Portfolios.
For definitions of the terms in the chart above, please visit the glossary.
The comparative outperformance of EM small versus large caps is more dramatic—which is why we also maintain a strategic allocation to EM small caps within our Model Portfolios.
Heading into this year, we were optimistic on EAFE and EM allocations relative to the U.S. The ongoing economic slump in China, the invasion of Ukraine and the fairly relentless strengthening of the dollar now give us pause; therefore, we remain in line with the MSCI ACWI Index with respect to our geographic allocations. We added to our U.S. small-cap allocation at the beginning of the year, funding it with a reduction to large-cap growth stocks.
On a relative basis, that trade has worked well for us (i.e., large-cap growth stocks fell more than small-cap stocks), but small caps continue to underperform on an absolute basis relative to large caps. We believe that may change over the course of the year because we believe we may see another “economic reopening” cycle at some point in 2022.
Equity Risk Factor Review and Outlook
The first quarter saw a dramatic “factor rotation” in the U.S. away from large-cap growth and toward value and dividends. The dispersion between the performance of value and growth stocks is now as wide as it has ever been. Interestingly, because the fixed income market also suffered during the quarter, value and dividend stocks provided the better “hedge” to the equity market downturn.
U.S. Factor Return YTD as of 3/31/2022
The performance dispersion between high-dividend stocks and non-dividend-paying stocks was dramatic.
Year-to-Date S&P 500 Dividend Yield Quintiles Performance
We also witnessed the outperformance of value and dividend stocks in small caps.
The performance dispersion between high-dividend stocks and zero-dividend-paying stocks in small caps was almost as dramatic in large caps.
Year-to-Date Russell 2000 Dividend Yield Quintiles Performance
Although large-cap stocks outperformed small-cap stocks at the asset class level, we saw outperformance of smaller-cap stocks within the large-cap Index due primarily to the dramatic decline of large-cap growth stocks over most of the quarter. (We use the S&P 500 Equal Weight Index as a proxy for smaller-cap stocks within the S&P 500 Index.)
Another interesting dispersion between large caps and small caps is the performance of the quality factor. Within small caps, quality shined. (We define quality as firms that have strong earnings, balance sheets and cash flows.) Here, we compare the S&P 600 Index to the Russell 2000 Index—the S&P 600 is considered the higher-quality Index because it eliminates more negative earning companies than the Russell 2000 Index.
But this quality trade has yet to show up in large-cap stocks. We believe it will as we move through what we believe will be an increasingly volatile 2022.
Most of the WisdomTree products and Model Portfolios have inherent factor tilts toward value, dividends and quality. This served us very well in the first quarter, especially the tilts toward value and dividends. We believe this trend will continue as investors increasingly focus on fundamentals and the “sooner rather than later” benefits of sustainable dividends and share buybacks.
We believe both the size and quality factors will become increasingly important as we move through 2022—a year we believe will be marked by increased volatility, rising rates and increasing geopolitical tensions but also by an “economic reopening regime” at some point during the year. This phase of the economic cycle historically benefitted the size, value, dividend and quality risk factors.
2022 has been an interesting year so far. We continue to believe there will be a valuation “tug of war” between generally solid earnings and rising interest rates.
Something we find interesting is that, for the past six months or so, the market “narrative” was that because growth and tech stocks are “longer duration” assets (because their earnings and cash flows are expected further out in the future), they were more highly sensitive to the rise in rates, hence their downturn over much of the quarter.
But growth stocks “caught a bid” in the past few weeks, despite the continued rise in rates, somewhat breaking that narrative. Our hypothesis is that this happened because valuations had fallen sufficiently to reattract investors.
How this “correlation” plays out over the remainder of the year remains to be seen. This is why we are adamant about being both asset class and risk factor diversified in our Model Portfolios—the market is smarter than we are, so we need to "spread our bets."
Our Model Portfolios and most of our products have inherent factor tilts toward dividends, value, quality and size. Given our economic and market outlook for the remainder of this year, we think that is a rather good place to be.
Important Risks Related to this Article
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