The Fed Shifts Its Focus to Inflation
With the Federal Reserve’s signaled policy shift in March, EIA’s proprietary monetary indicator identified the transition to a Restrictive monetary environment and a corresponding update in portfolio composition for the IFED indexes. We believe the updated portfolio optimally aligns the IFED indexes with the new Restrictive environment. With the shift, the Fed has signaled a change in its first priority - from promoting full employment to a focus on maintaining price stability. Such a major change in policy focus necessitates an extensive shift in portfolio composition.
In this commentary, we highlight the link between the IFED strategy, Fed signals and the composition of the IFED indexes, all in light of the recent shift in Fed policy.
Recap of Research & the Role of the Federal Reserve
In recent months, investors have become increasingly concerned about the interplay between inflation, economic conditions, and security returns. Based on the IFED rules-based methodology, signaled shifts in Fed policy dictate the timing of portfolio rebalances and portfolio composition. Our peer-reviewed research on Fed policy and its impact on security returns utilizes data that goes back to the 1960s. We confirm that systematic Fed-policy-linked patterns prevail in security returns during periods of high inflation in the 1970s and 1980s as well as the past 30-year period.
The Fed has a dual mandate to maintain price stability (i.e., keep inflation under control) and promote full employment. Fed actions, which the IFED strategy uses as policy signals, are predicated solely with these two goals in mind. Therefore, the Fed policy signals that underly the IFED strategy explicitly reflect current and future expectations regarding inflationary pressures and economic concerns. In other words, the IFED strategy’s unique design allows it to appropriately rebalance the portfolio to reflect the Fed’s forward expectations on price stability (inflation) and employment.
The IFED strategy relies on Fed policy signals and a diverse set of firm-specific financial metrics to select securities that are optimally aligned with prevailing market conditions. EIA uses the IFED monetary indicator to classify market conditions into three alternative environments – Expansive, Indeterminate and Restrictive. The following table offers a general overview of the three IFED market environments and their link with IFED portfolio construction.
IFED Market Environment and IFED Portfolio Composition
Based on the Fed’s actions earlier this month, the IFED indicator identified a shift from an Expansive environment to a Restrictive environment. Commensurate with this shift, EIA’s strategy tilted the IFED indexes toward equities with strong balance sheets and market stature.
Portfolio Composition Before and After March Rebalance
The following tables present composition characteristics for IFED-L before and after the March rebalance. IFED-L is EIA’s first customized index and was launched on June 9, 2020. There are currently two UBS issued Exchange Traded Notes (ETNs) trading on the NYSE that track IFED-L (stock codes: IFED and FEDL); both were launched on September 14, 2021.
IFED-L’s Largest Holdings and Sector Weights:
Before and After March Rebalance
IFED-L Portfolio Summary Statistics:
Before and After March Rebalance
The data in the tables confirms that IFED-L’s composition shifted markedly with the monetary environment change that occurred in March. As noted previously, this major shift in portfolio composition aligns with the substantial shift in policy focus signaled by the Fed. With such a shift, investors should expect that the best performing stocks in the new environment will differ significantly from those identified in the previous environment.
In the new portfolio, five of the ten largest holdings are financial firms and three are information technology firms. In contrast, the prior portfolio included only one firm in each of these sectors. While the IFED strategy targets individual firm metrics, due to the commonality of firm metrics across sectors, the portfolio witnessed a marked decline in holdings in the Energy and Materials sectors, with large increases in Financials, Health Care and Information Technology.
As noted above, during restrictive environments, the IFED strategy favors stocks with strong balance sheets and market stature. These features are confirmed by the shift observed in the portfolio summary statistics. Specifically, the median cash/debt ratio indicates that on average the firms in the current portfolio have sufficient cash to cover 46% of their debt, whereas the previous percentage was only 32%. Thus, the average balance sheet strength of the firms in the reconstituted portfolio has improved considerably. Furthermore, the large increase in average market cap and significant decrease in price/book (P/B) ratio indicate that the newly formed index contains firms with greater market stature. Larger firms with lower P/B ratios are more established in the market and are less reliant on growth options for their success.
The newly initiated Restrictive environment signaled by the Fed portends a period of higher interest rates, tighter markets for capital and increasing inflationary pressures. Overall, the post-March changes in financial features align with firms that have the where-with-all to prosper in a Restrictive environment.
IFED-L Performance Since Index Launch
The following table presents IFED-L performance data for various periods since IFED-L was launched on June 9, 2020.
IFED-L Performance through March 31, 2022
The performance data confirms that the IFED strategy has been extremely successful at producing alpha. The strong performance over this turbulent time supports the strategy’s robustness. Specifically, the 23-month period since IFED-L launch has witnessed the following major market conditions: strong economic recovery following the initial phase of the Covid pandemic, anxiety over new Covid variants, heightened inflation fears due to supply chain issues, and the invasion of Ukraine by Russia. IFED-L successfully navigated these diverse conditions as witnessed by the 23.78% alpha since launch, the 17.87% alpha since ETN listing and the 14.29% alpha since last rebalance.
Long-Term Performance of IFED Indexes
While IFED-L is EIA’s first customized index offering, EIA has a suite of IFED indexes available to investors. This section presents the performance of the six indexes currently comprising the EIA suite of indexes.
As illustrated above, the IFED strategy (as proxied by IFED-L) has shown superior performance over recent months. The strategy’s design, however, is formulated to take advantage of long-term established patterns in stock returns. Therefore, the strategy is best judged based on its long-term performance. With that in mind, the following graph illustrates the back-tested 5-year levels of annual outperformance (alpha) for each of six alternative IFED indexes in EIA’s suite. Each indexes’ alpha is plotted relative to its identified benchmark. The graph shows annual 5-year rolling alphas derived from returns over the period January 1999 through March 2022.
There are several conclusions that can be drawn from the outperformance (alpha) plots:
the tremendous outperformance (alpha) of IFED-L over recent months coincides with the long-term evidence, i.e., the index’s short-term superiority is not an aberration;
the robustness of the IFED strategy is supported by the observation that all six IFED indexes show superior performance (positive alpha) throughout most of the 23-year time-frame;
over the 23 years, the negative alphas that occur are infrequent in number and small in size; and,
the IFED strategy has shown strong resiliency in each case of index underperformance, i.e., performance rebounds nicely shortly thereafter.
Overall, the consistency and superiority of the performance of the IFED indexes substantiates the efficacy of the IFED methodology. The IFED strategy’s historical outperformance aligns with the strategy design as highlighted in the following points.
Significant underperformance occurred infrequently - the strategy positions the portfolio to prosper when normal return patterns prevail yet integrates a downside risk management component. Relative downside risk is avoided by keeping the portfolio fully invested, favoring stocks with quality financial metrics and adjusting portfolio composition to avoid holding stocks that are incompatible with prevailing market conditions.
Performance did not revert to the mean - the strategy adjusts portfolio composition, so that it is kept in alignment with prevailing market conditions. Factor approaches and smart-beta approaches often experience performance that reverts to the mean because the strategies are static, and thus, go in and out of favor.
Several periods of strong outperformance occurred – the strategy positions portfolio composition to prosper when long-term, established return patterns reveal themselves. While unusual factors can drive security returns over short periods, the long-term patterns that underpin the IFED methodology prevail over time.
Renowned poet Maya Angelou once said, “When people show you who they are, believe them the first time.”
Similarly, we believe that when the Fed signals a changing interest rate environment, you should believe them and act accordingly.