Navigating market uncertainty: A sector and factor approach
With the S&P 500 off to its eighth-worst start in 50 years1, and uncertain macroeconomic regimes moving forward, many investors are understandably concerned about how to position their portfolios.
Frec strives to give investors more options and the right tools to express their market views. In that vein, we have launched two new indices: The CRSP US Large Cap Value Index and the CRSP US Large Cap Growth Index. We also launched a new feature that allows investors to adjust weight factors at the stock or sector level2.
When markets become volatile, simply holding broad market indices may expose investors, like those with shorter time horizons, to levels of risk they are not comfortable with. Breaking down an index into sectors or factors can offer more targeted exposures during various market regimes, potentially improving risk-adjusted returns and a better fit for an investor’s needs.
Factor investing overview
Factor investing targets specific drivers of return across asset classes. These “factors”—such as company size, risk, and value—were popularized by the work of Eugene Fama and Kenneth French, and are historically linked to the generation of consistent excess returns or risk premiums beyond market risk over long periods. However, it is important to note that past results do not guarantee future performance, and factor returns can vary significantly across different market cycles and economic conditions.
Frec offers investors exposure to the following factors:
– Value: This is a composite measure derived from five financial ratios that typically indicate a company might be undervalued relative to its fundamentals. These ratios compare the company’s stock price to its book value, future earnings, historical earnings, dividends, and sales.
– Growth: This is a composite measure based on six indicators suggesting a company’s potential for future expansion and profitability. It incorporates metrics related to future earnings growth, historical earnings and sales growth, investment relative to assets, and return on assets.
You can read more on how CRSP constructs these factor models here.
Source: Dimensional
Value stocks historically perform well during periods of economic expansion and rising interest rates as investors seek out companies trading at a discount with strong potential for earnings growth. The basic principle is that the expected returns should be higher if you pay less for set cash flows. The year-to-date value has also significantly outperformed growth stocks as investors seek more stable companies and de-risk from concentrated growth stocks.
Growth stocks, conversely, typically thrive in low-interest-rate environments and periods of technological innovation, where investors prioritize companies with high revenue growth and future potential over current earnings. Understanding these conditions allows investors to strategically allocate their portfolios based on their outlook for the market and economy, potentially enhancing returns and managing risk.
For those who want to stay invested in American markets but are concerned about high valuations or the significant concentration of mega caps, tilting on value stocks can be a defensive strategy. Value stocks may result in paying less for a stream of cash flows, and value portfolios often provide higher dividend income compared to growth stocks, which typically reinvest profits rather than distributing them to shareholders. On the other hand, for those who believe that the current momentum of growth stocks will persist and that it is important to capitalize on successful investments, a growth index can provide a way to increase exposure to that factor.
Equity and sector weight modifications
To give our investors more flexibility in index customizations, we have released a feature for scaling up or down stocks/sectors within an index. This powerful feature allows investors to make critical adjustments based on their investment strategies and can be particularly useful for those seeking defensive exposure to their portfolio.
Historically, sectors have been useful groupings to enable investors to express views on macroeconomic conditions. For example, in the S&P 500, the Energy and Info Tech sectors have historically traded in an inversely correlated manner:
Research by S&P Dow Jones Indices demonstrates the cyclical performance of sectors in different market regimes and how they relate to each other and the macroeconomic world around them. Sector adjustments can be used to tilt your index into more defensive or aggressive posturing, as well as a non-exhaustive list of qualities listed below:
| Objective | Why sectors work |
| De-risking in drawdowns | Defensive sectors (Consumer Staples, Utilities, Health Care) carry lower beta and historically outperform in bear markets |
| Pro-growth positioning | Cyclicals (Tech, Industrials, Financials, Materials) lead in expansions |
| Inflation hedge | Energy & Materials earnings rise with commodity prices |
| Rising-rate hedge | Financials benefit from steepening curves; Utilities/REITs lag |
| Concentration control | Cap-weighted indices can become dominated by mega-cap Tech |
| Hedging employer-stock risk | It may make sense to divest/underweight from your own company’s sector if you hold a lot of company stock or exposure to that sector already |
| Income targeting | Utilities and REITs provide higher dividend yields |
These relationships allow investors to tilt their index in favor of different economic regimes. Suppose an investor in the S&P 500 is concerned with the current state of the stock market; they may choose to tilt their sector weights by amplifying the weights assigned to Consumer Staples and Utilities, both of which have demonstrated positive excess performance during market drawdowns.
S&P 500 sectors allow investors to adjust, make tactical moves, and diversify effectively, often outperforming individual stocks or even the index at large. Sector leadership changes predictably with market conditions, and Frec allows investors to preempt these changes and allocate accordingly.
Adaptability is key
At Frec, we believe that allocating investments into a broadly diversified index fund can be an effective strategy for most investors with long-term investment horizons. This approach offers simplicity, diversification, and generally lower costs. However, we recognize that not all investors have the same needs or objectives. For those with a shorter investment time frame, who require immediate access to their capital or wish to strategically adjust their portfolio by increasing or decreasing exposure to a specific factor or sector, Frec offers a range of tools designed to empower them to achieve their unique financial goals. These tools offer flexibility and control, allowing investors to tailor their investment strategies to their circumstances.
