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The Fed’s Focus on Inflation Continues – Are Your Portfolio Holdings Still Appropriate?

Posted: July 21, 2023


In this commentary, we highlight the link between Nasdaq IFED index performance, the principles behind the IFED strategy, and the changing composition of the Nasdaq IFED indexes.


The Federal Reserve has a dual mandate to maintain price stability and promote full employment, which sounds like a fairly straightforward assignment. The problem is that these two objectives tend to respond in opposite fashion to Fed stimulus. Thus, the Fed walks a fine line regarding the actions needed to maintain the proper balance in pursuing its objectives. For example, in the current atmosphere, to avoid letting inflation spin out of control, the Fed has been compelled to apply policies that push interest rates higher; however, rising interest rates diminish economic activity and consequently reduce employment opportunities.


Based on current conditions and the Fed’s outlook for the economy, the Fed may take actions to tip the scales to lean toward one or the other objective. Through its research, the EIA team determined that Fed policy signals can be used to effectively identify which objective the Fed is prioritizing. An “expansive” environment aligns with the Fed prioritizing full employment, whereas a “restrictive” environment corresponds with the Fed prioritizing price stability. Finally, when the Fed applies a truly balanced approach to its objectives, the environment is considered “indeterminate.”


Based on years of academic research, the EIA team determined that the stocks best positioned to prosper in one market environment differ materially from those best positioned for the other two environments. The IFED strategy relies on twelve firm-specific metrics[1] to select stocks with features that match the identified market environment. According to the IFED strategy, since March 2022, the Fed has prioritized price stability, and thus, Nasdaq IFED indexes have maintained holdings that align with a restrictive environment.


Nasdaq IFED indexes reconstitute and rebalance for one of two possible reasons: 1) the Fed signals a shift in the objective it is prioritizing, or 2) the underlying portfolio requires updating to reflect changes in the twelve metrics. The last two reconstitutions exhibit each of these reasons as the March 2022 reconstitution was due to a signaled shift in Fed policy, whereas the most recent reconstitution on June 9, 2023, was initiated to update portfolio holdings to reflect changes in the twelve metrics.


Performance of Nasdaq IFED Indexes – Before and After Launch

The performance of the Nasdaq IFED US Large-Cap Index (Nasdaq IFED-L) and the Nasdaq IFED US Large-Cap Low Volatility Index (Nasdaq IFED-LV) before and after launch is shown in Exhibit 1.

Nasdaq IFED-L vs S&P 500

* Not annualized.


The graphs in Exhibit 1 illustrate the superior performance of Nasdaq IFED-L and Nasdaq IFED-LV relative to their respective benchmarks over the period from January 1999 through May 2023. The final cumulative value for each index far exceeds that of its benchmark: 2,588 vs. 533 for Nasdaq IFED-L and 1,747 vs. 755 for Nasdaq IFED-LV. The outperformance for the two indexes continued throughout the period as the divergence between the two lines depicted in each graph continued to expand across most of the period.


The consistency of outperformance for the indexes across the two periods is confirmed in the two tables following the graphs. Specifically, Nasdaq IFED-L reported a notable live-period alpha of 4.92%, while Nasdaq IFED-LV reported an even more impressive 6.45% live-period alpha. Finally, for each index, the superiority of its live-period performance is shown to correspond with its outperformance over the long-term back-tested period, which helps validate the robustness of the IFED strategy.


Characteristics of IFED Market Environments and Index Holdings


The IFED strategy relies on Fed policy signals and twelve firm-specific financial metrics to select securities that are optimally aligned with the identified environment. As indicated above, EIA uses the IFED monetary indicator to classify market conditions into one of three alternative market environments – expansive, restrictive, or indeterminate. The following table offers a general overview of the three IFED market environments and their link with IFED portfolio construction.


Exhibit 2: IFED Market Environment and IFED Portfolio Composition

According to the IFED rules-based methodology, Nasdaq IFED indexes are reconstituted to maintain alignment between index holdings and the market environment. A June 9, 2023, reconstitution occurred to renew index holdings based on updates in the twelve financial metrics. Thus, index holdings continued to favor stocks with strong balance sheets, positive price momentum, attractive valuations, and market stature.


Portfolio Composition Before and After June 9, 2023 Reconstitution


The following tables present the largest holdings and sector weights for the old and new portfolios underlying Nasdaq IFED-L and Nasdaq IFED-LV.


Exhibit 3: Nasdaq IFED-L Composition: Before vs After Reconstitution

* The old portfolio features are as of May 31, 2023.


The June 9, 2023 reconstitution was motivated by a requirement to update holdings based on the most recent financial metrics. With the reconstitution, the portfolio was repositioned to highlight the up-to-date firm-specific metrics that correspond with the continuing restrictive environment. As illustrated in the tables, there was considerable movement in Nasdaq IFED-L’s index holdings. Only three of the ten largest holdings are consistent across the before and after versions: Lam Research, Bank of America, and Palo Alto Networks. Both groups of holdings, however, include firms with strong balance sheets and established, prominent positions in stock and financial performance. More generally, only 35 stocks from the old portfolio remained in the new 75 stock portfolio, which reflects the significant movement in stock IFED Scores since the last index reconstitution in March 2022.


The prominent shift in holdings is highlighted by the large changes in sector composition, particularly for Financials and Energy. The allocation to Financials dropped considerably, from 39.46% to 14.78%, whereas the allocation to Energy increased from 0.74% to 14.18%. The holdings adjustments were motivated by a combination of changes in the twelve firm-specific metrics, but key drivers were the relative market and earnings performance for the stocks within these sectors. The IFED model gives preference to firms with relatively strong movements in earnings quality and stock performance during restrictive environments.


Exhibit 4: Nasdaq IFED-LV Composition: Before vs After Reconstitution

* As of May 31, 2023.


The investment set for Nasdaq IFED-LV includes the 150 lowest volatility, large-cap U.S. stocks. Given the smaller potential investment pool available for Nasdaq IFED-LV versus Nasdaq IFED-L, the index experienced less turnover. Just like Nasdaq IFED-L, however, there are only three stocks in the top 10 largest holdings that appear in both the before and after versions of the portfolio: Cardinal Health, Vertex Pharmaceuticals and Aflac. More generally, only 30 stocks from the old portfolio remained in the new 75 stock portfolio due to changes in stock IFED Scores since the March 2022 reconstitution.


The sector composition tables confirm the greater consistency in holdings between the before and after groups. The biggest increases in sector composition occurred for Consumer Discretionary (4.97% to 13.83%) and Information Technology (5.99% to 10.57%), whereas the largest decreases were for Health Care (33.73% to 25.95%) and Financials (27.10% to 20.34%). Nasdaq IFED-L and Nasdaq IFED-LV each consistently apply the IFED methodology but start with unique investment sets. Therefore, the shift in allocations was motivated by comparable updates in the twelve financial metrics. As with Nasdaq IFED-L, key drivers in the allocation change for Nasdaq IFED-LV were movements in relative earnings quality and stock performance.


Wrap Up

With its dual mandate, the Federal Reserve is given a tremendous responsibility, which entails maintaining a healthy growth in the U.S. economy to promote employment opportunities, while avoiding a growth rate that promotes undue inflationary pressures. In implementing its mandate, the Fed relies on the powerful tools it possesses, which include controlling the money supply and interest rates and serving as lender of last resort in a financial crisis situation. When the Fed shifts its policy priority, it does so based on its assessment of current and forecasted economic and market conditions. In shifting policy, the Fed also incorporates its superior access to data and information–the Fed is privy to the impact its actions are yielding in the financial markets and is also cognizant of its future action plan.


If the Fed believes that current and forecasted conditions warrant a fundamental shift in policy priority, the team at EIA believes that it is prudent for investors to adjust their portfolios accordingly. EIA’s founders spent their academic careers (over 30 years of research) investigating the most appropriate portfolio response to a signaled shift in Fed policy. EIA’s research confirms that relying on Fed policy shifts to guide portfolio composition can be very effective, but only if investors implement the appropriate response. We believe that investors ignore the Fed at their own peril; however, it is equally dangerous to adjust one’s portfolio improperly.



Disclaimer

Nasdaq® is a registered trademark of Nasdaq, Inc. The information contained above is provided for informational and educational purposes only, and nothing contained herein should be construed as investment advice, either on behalf of a particular security or an overall investment strategy. Neither Nasdaq, Inc. nor any of its affiliates makes any recommendation to buy or sell any security or any representation about the financial condition of any company. Statements regarding Nasdaq-listed companies or Nasdaq proprietary indexes are not guarantees of future performance. Actual results may differ materially from those expressed or implied. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED.

© 2023. Nasdaq, Inc. All Rights Reserved.

 

[1] 1) Market Cap; 2) Long-term Performance; 3) Short-term Performance; 4) Relative Value; 5) Dividend Yield; 6) Cash Ratio; 7) Variability; 8) Change in Net Operating Assets; 9) Balance Sheet Bloat; 10) Equity Issuance; 11) Debt Ratio; 12) Profit Margin

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