A while ago I created some charts to track factor performance in the US equity market. The data is from Ken French’s Data Library. As you might expect, it is the Fama French Five Factor data, as well as data for the North American Momentum Factor.
From an analytical point of view I always find it helpful to dis-aggregate investment returns, as this can offer a more nuanced picture of the fundamental drivers of equity market returns.
Our first factor is Market. Looking at this chart it’s no wonder there has been a bull market in passive investing lately. Since May of 2014 simply being in the market has return a cumulative 45%. Getting market exposure as cheaply as possible has proven to be a great strategy over this time period.
Next up is size. As a whole small companies have not generated much of a return premium in recent years.
Value is a much beloved and storied factor and if you follow markets at all you have probably read plenty of material calling value investing into question lately.
Momentum has taken investors on a wild ride in recent years. 2015 in particular was an exceptional year for momentum, driven in large part by internet technology and biotechnology stocks. Despite a vicious drawdown in late 2015 and early 2016 momentum is surging again on the back of bullish sentiment.
Nothing to write home about in terms of operating profitability.
Investment is more or less the mirror image of the momentum chart. The investment factor is a bit counter intuitive in that it is measuring the premium associated with a conservative corporate investment policy. There have been a couple of inflection points in this chart and more recently investors seem to again prefer companies investing more aggressively in growth opportunities.
Finally, here is my updated chart of rolling factor returns back to 2000:
Observations & Implications
The most significant takeaway from this data is that since the financial crisis, the best performing factor has been Market by a wide margin. I don’t believe it is an accident that strong Market factor performance coincides with both the trend toward passive investing and the extraordinarily low interest rate environment we have seen since the financial crisis. I suspect there is some degree of feedback loop in play here: low interest rates push up equity valuations which enhances broad market returns which is a tailwind for low-cost, market cap weighted equity funds (a.k.a index funds).
Furthermore, since the financial crisis several factors have shown muted performance versus their pre-crisis averages, notably Size and Value. This is a headwind for active mutual fund managers. Most of these managers run diversified portfolios where the factor exposures drive the majority of the variation in their returns. If they are good (or lucky) they will add some incremental return through security selection. Many managers also intentionally tilt their portfolios toward small stocks and value stocks. They have not been rewarded for these tilts in recent years.
The trillion dollar question here is whether Market factor dominance is a secular or cyclical trend. I am inclined to believe it is cyclical, albeit with a significant caveat.
My significant caveat is that Market factor dominance will last at least as long as global interest rates remain low. In this low rate environment the notion that There Is No Alternative forces capital that would otherwise be content to earn 5% annually in long-dated Treasury bonds into risk assets, pushing up valuations indiscriminately. Until investors with lower risk preferences determine they have viable investment alternatives, equity valuations will remain elevated across the board and the Market factor will perform well.
Sentiment seems quite bullish so far in 2018. This has animated the spirits of a number of investment managers. Yet here is the YTD data for the Treasury yield curve. The market is absolutely not pricing for significantly higher economic growth, inflation or interest rates over the very long term (20-30 years). I am not sure there is any actionable insight in this but it is a troubling disconnect.