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 this past March, and 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.

But, as regular readers know, 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.

2023 YTD Risk Factor Review

2022 witnessed one of the greatest factor rotations in history, as growth fell to earth and value roared back to life.

That “factor rotation” completely reversed itself in the first six months of 2023 (here, we use the S&P 500 Index as a proxy for the broader markets), as the market was dominated by a small handful of artificial intelligence (AI)-themed mega-cap tech stocks.

Here is the 2022 factor performance…

…in comparison to the same factor performances YTD through June 30, 2023:

BUT look at how those factors have “re-rotated” over the past 4–6 weeks—dividends, value and quality have moved back to the “top of the charts” while growth has fallen back.

Why has this happened? Has “AI” fallen out of favor? We think most definitely not. We think the answer comes down to valuations. Here is a comparison of the forward-looking P/E ratios of the “MegaCap-8” (Alphabet [Google], Apple, Amazon, Meta [Facebook], Microsoft, Netflix, Nvidia and Tesla) versus the rest of the market.

We think investors are simply beginning to wonder if the future earnings potential of those “MegaCap-8” stocks can support such frothy valuations and are beginning to refocus on more attractively priced areas of the market (e.g., value and small cap).

And it is not simply that those other market areas are valued relatively attractively to the mega-cap growth stocks—they are also valued attractively relative to their own history.

While large-cap stocks have dominated this year, we may be beginning to see small caps “close the gap.”

What about the Remainder of 2023?

As we move through the remainder of 2023, the open question is whether the value, size and dividend “re-rotation” will continue. If we are correct in our view that interest rates will remain range-bound and “higher for longer,” then we think the answer is yes, assuming investors “fade” (or simply capture profits from) the AI trade and refocus on fundamentals and valuations.

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 greater ability to protect their margins and dividends.

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.

Taking a brief look outside the U.S., valuation- and dividend-focused investors may like what they see over a reasonable time horizon.

International Equities Forward P/E Discount to U.S.: MSCI ACWI ex-USA vs. S&P 500

Quality Dividend Growth Index Trailing 12-Month Dividend Yields

Conclusions

We remain comfortable with the positioning, allocations and tilts within our Model Portfolios (dividends, value, size and quality), especially since we believe in risk factor diversification and therefore allocate to the growth factor as well. The result has been that our portfolios have “held their own” in 2023 despite the mega-cap tech “headwind.”

It is too early to tell if the recent “re-rotation” back toward dividends, value and size will continue, but we believe that it will over a reasonable time horizon. Ultimately, fundamentals matter, not just trends and “memes” (though sentiment and momentum can carry a factor rally far beyond its underlying fundamentals).

As a reminder, 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; and

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.

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