Risk Factors Are Rotating Back into Focus

This article is relevant to financial professionals who are considering offering model portfolios to their clients. If you are an individual investor interested in WisdomTree ETF Model Portfolios, please inquire with your financial professional. Not all financial professionals have access to these Model Portfolios.

Regular readers of the WisdomTree blogs know that we write frequently about risk factor diversification. As we approach the halfway point of what has been a very turbulent 2022, it is time to revisit this important topic.

As a reminder, most investors are familiar with the visual of an asset class “performance quilt,” which highlights the importance of asset class diversification.

For definitions of terms in the image above, please visit the glossary.

But we believe risk factor diversification is equally as important as asset class diversification. And risk factor performance can be as difficult to forecast as asset class performance.

 For definitions of terms in the image above, please visit the glossary.

Year-to-Date Review

The first half of 2022 was unusual in the sense that bonds did not provide the hedge to equity risk they historically have.

For definitions of terms in the image above, please visit the glossary.

Certain equity risk factors, specifically dividends and value, were more effective hedges to broad market equity risk.

Conversely, the rising interest rate environment over the first half caused havoc with growth stocks (i.e., stocks whose cash flows are expected further out in the future and so whose “discounted cash flow” valuations are therefore more sensitive to rising rates).

U.S. Factor Return YTD, as of 5/31/22

For definitions of terms in the image above, please visit the glossary.

Within small-cap stocks, we also see that quality was an important risk mitigator (using the S&P 600 versus the Russell 2000 indexes as proxies for the quality factor, as the S&P 600 index excludes far more negative earnings companies than the Russell 2000 index).

As a final factor to examine, let’s look at size. Within U.S. large-cap stocks, we see year-to-date (YTD) outperformance by the smaller-cap stocks within the index (using the S&P 500 equal-weighted index as a proxy for those smaller-cap stocks).

For definitions of terms in the image above, please visit the glossary.

But, at a broader level, U.S. large-cap stocks outperformed U.S. small-cap stocks.

We saw similar (and more dramatic) YTD underperformances with EAFE and EM small-cap stocks in comparison to their respective large-cap indexes, though non-U.S. small-cap stocks have outperformed non-U.S. large-cap stocks over longer time horizons (e.g., 10 years).

Outlook for the Remainder of 2022

As the Fed (and other central banks) engages in more aggressive rate hike regimes, we see the market interpreting that as a signal for impending recession. The result has been a mini rally in growth stocks over the past two weeks as investors have leaned away from value-oriented sectors such as financials, utilities and especially energy.

For definitions of terms in the image above, please visit the glossary.

Despite this, we believe that value and dividends will outperform over the remainder of the year. We further believe that quality will become increasingly important as we head into an uncertain economic environment marked by generally rising interest rates and increased market volatility. We believe that investors will once again refocus on companies that exhibit stronger earnings, cash flows and balance sheets.

For valuation-driven (and therefore longer-term) investors, U.S. small-cap stocks present an interesting potential opportunity—the market has driven small-cap valuations down, seemingly in expectation of a sooner-than-we-expect recession. 

Let’s compare commonly-used valuation metrics of the S&P large cap and small cap indexes (labeled “500” and “600”, respectively, in the chart below) – we see a significant discount in the small cap index numbers versus the large cap index numbers. Since what you can earn on any investment is at least partially a function of how much you pay for it today, longer-term investors may see a relative attraction to small cap stocks, despite the current market environment.

A more historical perspective tells a similar story—despite the downturn so far this year, mid- and small-cap stocks remain more attractively valued than large-cap stocks.

Conclusions

Given the factor tilts inherent in many, if not most WisdomTree strategies (dividends, value, size and quality), we remain comfortable with the positioning and allocations within our Model Portfolios. Most of our strategic models are benefitting from these factor tilts and are beating their respective benchmarks YTD.

Given the difficulty in forecasting asset class and risk factor performances, however, we intentionally diversify our portfolio at both of those levels.

As a reminder, almost all publicly available WisdomTree Model Portfolios have certain common characteristics:

1. They are global in nature
2. They are diversified at both the asset class and risk factor levels
3. They are ETF-focused, to optimize fees and taxes
4. We charge no strategist fee

We are an open-architecture shop (that is, all our Models include both WisdomTree and third-party products) for many reasons: (a) it’s the right thing to do, (b) it’s what end clients assume, and advisors expect, and (c) it allows us to build more risk factor-diversified portfolios.

We like the factor tilts currently embedded in our Model Portfolios, as we believe dividends, value and quality will continue to shine as we move through 2022. We also believe size may be positioned for a positive rotation.

Given our strategic investment mandates, however, we also remain diversified at both the asset class and risk factor levels.