What is the best investment style?

For decades investors have debated which investment style is superior, does small-cap-value dominate, or how about large-cap-growth; perhaps, high dividend stocks with momentum, or low volatility stocks with high profitability? There are numerous alternative styles that are advocated by novice investors and investment professionals alike. Investors tend to be passionate advocates for the investment style they have chosen; however, most investors have learned the hard way that investment styles go in- and out-of-favor.


The question of which investment style is best, is reminiscent of the sage advice I received prior to a fishing trip. Several years ago, I was scheduled to go on a fishing trip with my dad later that year. In preparation for the trip, I called Dad and asked him what lure I should buy to bring on the fishing trip. I knew that the various lures included plugs, jigs, and spinners, and furthermore, once the type of lure was selected, I would have to choose the best color combination. Anyone who has wandered through a bait-and-tackle shop will clearly understand that without some guidance, selecting the appropriate lure is almost impossible.


Fortunately, Dad was there to bail me out. His response to my question was, “Son, only a fool would select their lure before knowing the fishing conditions.” He further explained that the optimal lure depends on weather conditions, time of day, water temperature and a lot more. He went on to assure me that he had an appropriate selection of lures and baits, and he would identify the option that aligned best with the prevailing conditions when we ventured out.


The team at EIA believes selecting an optimal investment style is analogous to selecting the best fishing lure; it cannot be done without assessing prevailing conditions. Market conditions dictate which firm features an investor should favor when selecting a portfolio of stocks. Just as the best lure last month may not work this month, the investment strategy that matched market conditions last month may not match the current market environment.


Basis of the IFED Strategy


The EIA team applies the IFED strategy, which relies on Fed policy signals to classify market conditions into one of three alternative environments, Expansive, Restrictive or Indeterminate (mixed). The IFED strategy then relies on twelve firm specific metrics to identify the portfolio of firms that is best positioned to prosper during the identified market environment. The strategy is a rules-based, active approach that is based on over 30 years of peer-reviewed published research.


Early academic research by EIA’s founders established that market conditions, as identified by Fed policy signals, are instrumental in determining the success of alternative investment styles. In 1997 and 1998, the founders published two studies[1] documenting the dependence between investment style returns and market environment. These two research studies were instrumental in launching the founder’s academic research program, which focuses on the relationship between Fed policy shifts and capital market returns.

Ultimately, the founder’s research expanded beyond the size and value premium to include twelve alternative financial metrics and refinements to the classification of market conditions. The culmination of this research was the creation of the Invest with the Fed (IFED) strategy and the formation of EIA in 2018. The IFED strategy represents an executable version of the founder’s peer-reviewed research. The strategy uses twelve financial metrics to assign each stock an IFED Score, which reflects the stock’s likely capacity to prosper in the prevailing market environment.


Efficacy of the IFED Strategy


To illustrate the effectiveness of the IFED strategy, we present performance using back-tested data from the 1,500 largest U.S. firms for the period from 1999 through October 2022. The following bar chart shows the annualized returns for each decile portfolio based on ranked IFED Score. For illustrative purposes, an equal weight is applied to the components in each decile.


Exhibit 1: Annualized Return by IFED Score Decile (January 1999 – October 2022)

Exhibit 1 supports the efficacy of the IFED strategy as firms with the highest IFED Scores, i.e., those in the 1st decile, outperformed the equal-weighted portfolio of 1,500 stocks by 30.56% versus 18.63% or by 11.93% per year. The monotonic drop in performance across deciles confirms the strategy’s robustness in differentiating stocks with favorable features for the prevailing market environment from those stocks with less favorable features. Note, there is a material drop in performance associated with each decile step, which indicates the IFED strategy relies on an established pattern, rather than being driven by extreme observations in the data.


To avoid going in- and out-of-favor, the IFED strategy maintains a portfolio of stocks that updates appropriately with each signaled shift in market conditions. On average, IFED indexes rebalance about twice per year. EIA launched its first customized IFED index, Nasdaq IFED-L, which is a large-cap U.S. index, on June 9, 2020. Exhibit 2 illustrates the reallocation across stocks that has occurred for Nasdaq IFED-L since launch. The exhibit reports the top ten holdings of Nasdaq IFED-L across the last three market environments.


Exhibit 2: Nasdaq IFED-L, Top Ten Holdings for Last Three Rebalances

Exhibit 2 reports the top ten holdings for the live index and indicates that portfolio composition shifts substantially with each change in market environment. According to the IFED model, in August 2021, the market environment shifted to Indeterminate, in November 2021, it shifted to Expansive and in March 2022, it shifted to Restrictive. There are only a few cases where the holdings are common across two of the environments and no cases where a firm is represented in all three. The shifting portfolio composition is dictated by the IFED model and is necessary to maintain alignment with each newly created environment. Consistent with the IFED methodology, which selects quality stocks that are appropriately positioned for the environment, the companies identified are prominent, established firms.


Ultimately, the value of an investment strategy, or a fishing lure, is based on its verifiable output. As illustrated by Exhibit 3, since its launch, Nasdaq IFED-L has been the top performing large-cap index.


Exhibit 3: Nasdaq IFED-L Live Performance Relative to Other Large-Cap Indexes

Note, this period has included a variety of market events and market environments including a pandemic, severe supply chain disruptions, Russia’s invasion of Ukraine, a very accommodative monetary policy, a tightening Fed policy, and a high inflation environment. Despite these unusual events, the IFED strategy has outperformed other prominent investment strategies by a considerable amount.


Furthermore, Nasdaq IFED-L has also been the top performing index year-to-date (YTD) as shown in Exhibit 4.


Exhibit 4: Nasdaq IFED-L YTD Performance Relative to Other Large-Cap Indexes

Note, the YTD performance has been achieved during a period of tightening Fed policy and poor market performance, whereas the performance reported in Exhibit 3 corresponds with a generally favorable time for the market. Most strategies rely on either strong or weak market performance to produce their outperformance. In contrast, the IFED strategy rebalances to maintain alignment with the changing market environment, and thus avoids going out-of-favor. Note, several of the higher-rated indexes in Exhibit 3 are lower rated in Exhibit 4. This boom-and-bust pattern is typical for most investment strategies. While the Value indexes appear to have avoided this pattern, as any value investor can tell you, unlike the IFED strategy, value strategies have lagged substantially for several years prior to the last couple years.


Patience Is Not Always a Virtue


Just as a skilled fisherman selects a lure that is appropriate for the conditions, the EIA team believes that market conditions dictate which financial features should be favored when making investment decisions. The proverbial phrase, “patience is a virtue” is commonly advocated in fishing and in investing. The EIA team, however, believes that if you are applying an approach that does not fit the environment, you may be unnecessarily sacrificing success.


The payoff to patience often relies on the observation of “mean reversion,” which tends to support maintaining the existing stance. Experiencing mean reversion, however, often occurs due to an eventual return to the environment that existed previously. In contrast, the IFED strategy changes portfolio composition to align with market conditions, rather than waiting for conditions to return to their original state. Sticking with an investment strategy that is not working is analogous to the old fishermen that stubbornly stuck to his traditional lure. Toward the end of the day, when asked how his fishing was going, he responded, “If I catch the one that’s nibbling and two more, I will have three.”


 
References

[1] See GR Jensen, RR Johnson and JM Mercer, 1997. New evidence on size and price-to-book effects in stock returns. Financial Analysts Journal 53 (6), 34-42 and GR Jensen, RR Johnson and JM Mercer, 1998. The inconsistency of small-firm and value stock premiums. Journal of Portfolio Management 24 (2) 27-36.