Posted: January 30, 2024
2023 was a strong year for the U.S. stock market and for the IFED indexes. The stock market rebounded nicely in 2023 from its dismal performance in 2022.
As set out in Exhibit 1, the majority of IFED indexes outperformed their benchmarks in 2023. The exception was Nasdaq IFED-L, which delivered a solid 21.32% return vs. 26.29% for the S&P 500. The strong performance of the S&P 500 in 2023 can be largely attributed to the impressive performance of the ‘magnificent 7,’ which produced a return of approximately 74% for the year. The IFED strategy favored value stocks during 2023, and thus, maintained an underweight position in the magnificent 7 stocks. Excluding the magnificent 7, the S&P 500 returned only about 12% in 2023.
Exhibit 1 – Returns for IFED Indexes and Benchmarks, 2022-2023
The IFED strategy is designed to capture large outperformance when normal return patterns prevail while limiting underperformance when abnormal factors drive market returns. Index performance patterns over the past two years demonstrate the strategy’s alignment with its design. Specifically, the strategy outperformed substantially during 2022 when normal return patterns prevailed during a down market. All five IFED indexes easily beat their benchmarks. Nasdaq IFED-L led the way with an alpha of 17.16%. However, even the smallest alpha of 7.85% produced by Nasdaq IFED-LV is impressive.
In contrast, the first half of 2023 witnessed the emergence of abnormal return drivers, which produced some atypical return patterns. These unusual patterns negatively impacted the performance of IFED-M, and especially, Nasdaq IFED-L. These indexes were overweight financials during the period, and hence, their performance was diminished by the unexpected failure of three large regional banks in March of 2023. We discuss the abnormal return drivers further below.
Exhibit 1 shows that all five IFED indexes produced far superior returns to their benchmarks over the two-year period. The largest outperformance, 31.09%, occurred for IFED-S. All five IFED indexes avoided the deep dive in returns that occurred in 2022 and then took full advantage of the 2023 rebound in returns. Furthermore, four of the five IFED indexes produced superior returns in each of the two years.
The evidence in Exhibit 1 strongly supports the efficacy of the IFED strategy as the indexes excelled in both overall performance and performance consistency. Specifically, the IFED strategy produced superior performance over this challenging two-year period, which witnessed extreme divergence in performance with very weak general stock market performance in 2022 and very strong market performance in 2023.
What Abnormal Factors Drove Returns in the First Half of 2023?
In March of 2023, three large regional banks failed prompting fears of a banking crisis, which negatively impacted banks regardless of quality. Most of the IFED indexes held over-weight positions in financial institutions in early 2023. The IFED strategy uses quality metrics to select index constituents, thus, the overweight positions were dominated by financials with strong quality metrics. Nevertheless, virtually all financials were negatively impacted by the fears precipitated by what many portrayed as a looming banking crisis.
The IFED indexes maintained overweight positions in financial firms based on their alignment with the prevailing market environment. Specifically, at the time, financial firms generally had low betas, attractive relative valuations, strong balance sheets and price momentum. This overweight position paid off in 2022 as it helped the indexes outperform their benchmarks.
The IFED strategy selects stocks based on firm fundamentals and avoids emotional considerations. Therefore, the strategy can suffer during periods when prices are driven by panic trading or investor euphoria. Such trading explains much of market performance in early 2023 as financials were indiscriminately battered, while the magnificent 7 stocks soared. Four of the five IFED indexes rebounded from the abnormal return patterns of the first six months and produced positive alphas for the year.
What Makes the IFED Strategy Different from Other Strategies?
The IFED strategy is a dynamic index approach that combines the best elements of active and passive investing. The strategy gauges signals sent by Federal Reserve policy signals to identify changes in the market environment. The strategy then selects stocks that are best positioned to prosper in the identified market environment. Thus, the strategy integrates an active component that strategically adjusts portfolio composition to best match the prevailing market environment. However, the active element applies a rules-based methodology that avoids the damage inflicted on portfolios by active trading, which is all too often driven by emotional biases.
Overall, the IFED strategy implements an active component that strategically aligns index composition with the market environment, thus avoiding out-of-favor holdings when market conditions shift. This dynamic component differentiates the strategy from other factor indexes, which are static. Strategies that incorporate an active element generally use discretion to take tactical positions. In contrast, the IFED strategy maintains a strategic allocation that shifts only when a change in market conditions is identified via a rules-based model.
The strategy captures the advantages of a passive approach in that security selection is rules-based and the number of index reconstitutions is limited. Reconstitutions occur only when necessary to realign portfolio composition with market conditions.
Exhibit 2 shows returns for 2022 and 2023 for the alternative S&P 500 factor indexes and the ‘magnificent 7’.
Exhibit 2 – S&P 500 Factor Index Returns, 2022-2023
Exhibit 2 clearly shows the boom-and-bust cycles that plague investment strategies targeting a particular investment style. Performance is shown relative to Nasdaq IFED-L, which starts with a comparable investment universe comprised of the 500 largest U.S. stocks. Based on range of returns and two-year return, Nasdaq IFED-L produced superior performance relative to each of the alternative portfolios.
Stock market performance in each year was dramatically influenced by performance of the magnificent 7, for the worse in 2022 and the better in 2023. In each year, high beta, growth stocks represented the most extreme performers. For example, in 2023, the return for the magnificent 7 (Nvidia, Apple, Facebook, Tesla, Meta, Microsoft and Amazon) was an astounding 73.9%. As a result, the S&P 500 High Beta and Growth indexes returned 33.6% and 30.0%, respectively. The High Beta and Growth indexes, however, were the worst performers in 2022.
In contrast to the boom-and-bust cycle that afflicts factor-based strategies, the IFED strategy avoids deep bottoms by selecting quality stocks that align with the prevailing environment. See Exhibit 3, which illustrates the relative downside protection offered by the IFED strategy. When abnormal circumstances drive returns, performance is buffered because the IFED model incorporates several quality metrics in the stock selection process. When normal return patterns prevail, the IFED indexes prosper because the index constituents are optimally positioned with the environment.
Exhibit 3 – Nasdaq IFED-L vs S&P 500 and the Magnificent 7
How Do You Confirm that an Investment Strategy Works?
While most investors are enamored with a strategy’s short-term results, establishing the validity of a strategy requires attention to two fundamental items as follows.
First, it is crucial to establish consistency of performance over time. Does the strategy perform well over periods long enough to reflect a full business cycle? On average, business cycles last about 5.5 years. A strategy may produce superior performance during a particular phase of the business cycle while underperforming over the full cycle. It is well known that stocks with unique features dominate during each phase of the business cycle, so judging performance based on a single year is insufficient. Performance over a period of less than two years is likely to correspond with a single phase of the business cycle. Is the strategy effective only during a phase, or certain phases, of the business cycle?
Exhibit 4 reports back-tested returns for the IFED indexes and their benchmarks over long-term periods. The returns are consistent with the performance reported in Exhibit 1, which provides robust support for the efficacy of the IFED strategy. Note that the superior performance is consistent across all five indexes and across the timeframes reported in the exhibits.
Exhibit 4 – Long-term Annual Returns for IFED Indexes and Benchmarks
Second, it is imperative that investment strategies are validated by investigating the underlying foundation of the strategy. Does the strategy rely on sound economic fundamentals? The IFED strategy relies on the underlying principles that, 1) different stocks prosper under specific market conditions, and 2) a shift in Federal Reserve policy corresponds with a current and/or forthcoming change in market conditions. Based on over 30 years of research by finance academics, including EIA’s founders, the evidence provides resounding support for each principle underlying the IFED strategy.
Looking Forward to 2024
We agree with the consensus opinion that at some point in 2024, the Federal Reserve will shift policy to reflect a more accommodative stance. When will that shift occur? We don’t know, and we don’t really care. The IFED strategy is focused on answering the question of what should you do as an investor when the Fed “does” shift policy? From our perspective, that is the more pertinent question. When the Fed determines that current and forecasted economic conditions warrant a policy shift, the Fed’s actions will indicate they are implementing a policy shift. At that point, the IFED indexes will be reconstituted to include stocks that are best positioned to prosper in the new environment.
EIA’s founders devoted over 30 years of research perfecting the two fundamental features that underly the IFED strategy. The first feature is the indicator variable that determines the point where market conditions change. The IFED model gauges Fed policy actions to confirm that a “true” shift in policy occurred. The second feature identifies the twelve firm-specific metrics that best determine which stocks are optimally positioned to prosper in the identified environment. The two features are designed to work together and are of relatively little value separately.
Based on our rigorous model development and out-of-sample testing, we are confident that whatever 2024 brings, the IFED indexes will be positioned to prosper.