To The Moon

By Craig Lazzara, Managing Director, Core Product Management, S&P Dow Jones Indices

From https://www.indexologyblog.com/

Investment results in 2022 were distinctly different from those of the recent past.

The$S&P 500(.SPX)$ , which had doubled in the three years between 2019 and 2021, fell by more than 18% last year, and Exhibit 1 shows that there were regime shifts among factor indices as well.

Exhibit 1

The dominance of Value over Growth in 2022 was especially remarkable. The one-year Value-Growth spread stands at the 97th percentile over all 12-month intervals since mid-1996. Equally interesting is that six years had passed since Value’s last “win” in 2016.

What can we infer from these factor shifts? Here are three important things:

First, they suggest consideringpassive management to be the default position for any asset owner—regardless of whether he’s seeking broad equity market exposure from the S&P 500, or more targeted factor exposure from one of the indices in Exhibit 1 (or their many cousins). Most active managers underperform most of the time. That result holds true across capitalization and style segments: the same causes that make it hard for a core equity manager to beat the $S&P 500(.SPX)$ make it hard for a value manager to outperform the $S&P 500(.SPX)$ Value. An asset owner who opts forindicizedfactor exposure is likely to outperform an active manager operating in the same market segment.

Second, Exhibit 1 reminds us of the importance of patience. There are good theoretical arguments for whyvalue should outperformgrowth, whylow volatility should outperformhigh beta and whyequal weight should outperformcap weight—but even if completely correct, those are arguments about long-run performance. Many low volatility or value investors spent the years between 2019 and 2021 wondering if something important had changed. 2022’s reversal was welcome, but it was a long time coming. In investment management, as in life generally, gratification must sometimes be deferred.

Finally, Exhibit 1 raises an important philosophical question: what is the point of factor indices in the first place? A value-driven factor index tracks relatively cheap stocks. A low volatility index tracks stocks with below-average volatility. A quality index tracks stocks with strong balance sheets and profitability. Are these characteristics, or others like them, desirable in themselves, or are they means to a different end?

Low volatility indices, for example, arealmost always less volatilethan the benchmark from which their constituents are drawn, but as we saw above, they sometimes underperform. An asset owner who chooses Low Volatility because he wants less volatility is likely to be satisfied most of the time; his counterpart who chooses Low Volatility because he thinks it will outperform has much more potential for buyer’s remorse.

An investor who undertakes factor exposureas a means of outperformingshould understand that no factor index outperforms all the time, and that hisability to tolerate periodic underperformancemay have a major bearing on his success. The investor should strive to understandthe conditions that will facilitate a factor’s success. At least as importantly, he should be clear about his own goals and motivations.

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