With the Fed’s shift to tighter policy earlier this year, concerns about inflation and potential economic recession have ramped up and created turmoil in the financial markets. At EIA Investments, we believe such periods underscore the merits of an investment strategy that adjusts with changing market conditions.
Based on 30+ years of research, EIA designed the rules-based Invest with the Fed (IFED) strategy. 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.
The IFED strategy applies a combination of top-down and bottom-up approaches. Stock selection is bottom-up as it is based on twelve diverse, firm-specific financial metrics; however, the set of metrics applied is conditional on the prevailing market environment. This approach differs from traditional smart beta and factor strategies that apply a static methodology.
In this commentary, we highlight the merits of the IFED strategy by presenting information pertinent to the IFED Large-Cap US Equity index (IFED-L), which was developed for UBS as the basis of investable products, including two exchange-traded notes (ETNs). IFED-L’s 21.12% total alpha, since its launch on June 9, 2020, illustrates the strategy’s ability to prosper across a time frame that includes a diverse set of historic events.
Recap of Research & the Role of the Federal Reserve
EIA’s founder’s peer-reviewed research on Fed policy and its impact on security returns utilizes data that goes back to the 1960s. The founders 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 20-year period. The research confirms that the returns ascribed to the most prominent risk factors depend on the prevailing market environment, as identified by Fed policy signals.
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 concerning price stability (inflation) and employment, with employment depending on economic growth.
As illustrated in the table below, the IFED strategy separates the market into three alternative environments, Expansive, Indeterminate and Restrictive. Each environment is identified based on a unique set of Fed policy signals, corresponds with a Fed priority, and parallels a portfolio composition designed to optimally align with the environment.
IFED Strategy Characteristics
The Fed Shifts to Prioritizing Price Stability
In March of 2022, the IFED model identified a shift from an Expansive environment to a Restrictive environment, with a corresponding shift in portfolio composition. The shift in policy aligns with an upward trend in interest rates and a period of elevated inflationary pressures. With the initiation of a Restrictive environment, the IFED strategy favors firms that show balance sheet strength and financial viability. Such firms have the wherewithal to out-maneuver their competitors during periods when funds are expected to be less easily accessed.
The following two tables confirm the dramatic difference in IFED-L’s composition from the period before the shift (the end of February 2022) to the most recent month’s end, April 2022.
IFED-L Sector Composition:
Before March Rebalance Versus Current
IFED-L Largest 10 Holdings:
Before March Rebalance Versus Current
In the current 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.
IFED-L Portfolio Summary Statistics:
Before March Rebalance Versus Current
The summary statistics in the table above clearly demonstrate that on average, relative to firms in the February portfolio, the firms currently included in IFED-L are in a better position to meet their debt obligations, are less reliant on growth options for their valuation and have greater market stature.
On average, the current IFED-L composition includes firms that have features indicating they are equipped to prosper during an environment where accessing funds is anticipated to be more challenging and costly. Over time, we expect that this advantage will be reflected in stock performance, as it has for IFED-L over the past two years and for the IFED strategy since the 1960s.
Exchange-traded Products on IFED-L
On September 14, 2021, UBS launched an ETN to track the IFED-L index. The ETN trades on the NYSE and has a ticker symbol of IFED. In addition, simultaneously, UBS offered a leveraged version of the index that delivers a return of two times the IFED-L return. The levered ETN also trades on the NYSE and has a ticker of FEDL.
IFED-L’s Performance
As noted previously, the empirical evidence supports the efficacy of the IFED strategy as IFED-L produced significant alpha across a very diverse market period that prevailed since its launch on June 9th of 2020. During the subsequent two years, we have witnessed historic market events including: recovery from a pandemic, fears of new Covid variants, dramatic supply chain disruptions, historic levels of inflation, and Russia’s invasion of Ukraine. As shown in the following two illustrations, IFED-L has performed remarkably well during this time frame.
IFED-L and S&P 500 Cumulative Performance Since Launch
IFED-L Performance Since Index Launch
Since IFED-L’s launch in June of 2020, the index has produced returns that have far surpassed its benchmark, the S&P 500. While IFED-L’s recent performance is noteworthy, IFED-L’s long-term back-tested performance provides further comfort that the strategy relies on long-term, recurring market patterns. The long-term performance shows that since 1999 IFED-L has produced an average level of outperformance relative to the S&P 500 of 8.17% per year, which is similar to the annual alpha recorded since the index launched on June 9, 2020.
At EIA Investments, we believe that market conditions dictate the optimal investment strategy. In the current environment where investors are concerned about high inflation, rising interest rates and waning economic activity, the composition of one’s portfolio should align with these market conditions. Applying the same investment strategy across market environments, as is done by smart beta and factor approaches, is akin to trying to place a square peg in a round hole.