Risk Factors Keep on Rolling

Chief Investment Officer, Model Portfolios

03/06/2023

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.

Big wheel keep on turning
Proud Mary keep on burning
And we’re rolling, rolling
Rolling on the river

(John Fogerty and Credence Clearwater Revival, 1969, with an iconic cover by Ike & Tina Turner, 1971)

I last wrote about risk factor diversification last July, and it is well past 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.

But, as regular readers know, what we believe is as important as asset class diversification is risk factor diversification. And risk factor performance can be as difficult to forecast as asset class performance.

2022 Risk Factor Review

2022 witnessed one of the greatest factor rotations in history, as growth fell to earth and value roared back to life. The performance difference between the growth and value factors was one of the widest dispersions ever. We see that dividends also delivered significant outperformance.

While the chart above indicates that small caps underperformed, the chart uses the Russell 2000 as the comparison Index. If we use the higher-quality S&P 600 Index instead, we see a different story.

On a different front, non-U.S. investing also rebounded in 2022, as both EAFE and EM markets outperformed the U.S., despite the headwind of a strong dollar rally for most of the year.

What About 2023?

As we move through the first two months of 2023, we see much more volatile factor performances as the markets react to different economic reports and Fed actions/comments. Growth has mostly kept pace with value, while dividends are lagging.

At the same time, small caps have maintained and even widened their advantage over large caps.

Despite this increased “factor volatility,” we continue to believe that value and dividends will outperform over the remainder of the year, and further out into the future as well. Factor rotations, such as we witnessed in 2022, tend not to be one-year phenomena but rather multi-year cycles.

We further believe that quality will become increasingly important as we head into an uncertain economic environment marked by generally rising interest rates, a slowing economy and increased market volatility. We believe that investors will once again focus on companies that exhibit stronger earnings, cash flows and balance sheets and therefore have a greater ability to protect their margins.

For valuation-driven (and therefore longer-term) investors, U.S. small-cap stocks continue to present an interesting opportunity. Despite the narrowing of the gap between large- and small-cap valuations, small caps remain attractively valued on a comparative basis.

Russell 2000 Fwd. P/E (ex. Negative Earners) vs. Russell 1000

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 models are benefiting from these factor tilts and have beaten their respective benchmarks over the past 12–15 months.

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, all publicly available WisdomTree Model Portfolios have certain common characteristics:

They are global in nature;
They are diversified at both the asset class and risk factor levels;
They are ETF-focused to optimize fees and taxes; and
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 shine as we move through 2023. We also believe size is showing distinct signs of rotating back into favor.

Financial advisors can learn more about the WisdomTree lineup of Model Portfolios by visiting our Model Adoption Center.

Important Risks Related to this Article

Neither diversification nor an asset allocation strategy assures a profit or eliminates the risk of experiencing investment losses.

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