Economic Index Associates
1. What is Economic Index Associates?
Economic Index Associates, LLC (EIA) is a firm that creates investable indexes tied to macroeconomic indicators such as the IFED series of indexes, which are based on Federal Reserve policy. EIA licenses its proprietary, patent-pending indexes as the basis for financial products. With EIA’s services, clients can also design customized portfolios that meet specified characteristics, yet are comprised of securities that are optimally positioned for current economic conditions.
2. What is the story behind Economic Index Associates?
Economic Index Associates is the result of over three decades of research by widely-published finance professors Robert Johnson, Gerald Jensen and Luis Garcia-Feijoo. Their research focuses on Federal Reserve policy and how Fed decisions influence security returns. The three researchers meticulously document how Fed policy changes influence returns for a variety of asset classes; their findings are published in prestigious academic and practitioner peer-reviewed journals. The basic premise of their original research is captured in their book - Invest With the Fed (McGraw-Hill, 2015). The three were introduced to Albert Neubert, a globally recognized expert in the field of security indexes. After studying their research findings, Neubert became convinced that the strategy could be adaptable to an index format. The team designed an investment strategy incorporating their research findings. The result of their efforts was the IFED Large-Cap US Equity Index™ (IFED-L), which is the first product under the IFED index banner. The IFED indexes rely on a rules-based, transparent, replicable index methodology that has been thoroughly tested and independently verified by major global index providers. And as the saying goes, “let the performance speak for itself.” The IFED-L index has produced superior risk-adjusted performance over its backtest history, which began in 1999.
3. What is EIA’s investment philosophy?
The EIA investment philosophy relies on being fully invested and strategically reallocating assets when economic conditions warrant. Underlying the EIA approach is the view that asset reallocations are optimal following a fundamental shift in economic conditions. A reallocation involves shifting asset weights to over-weight securities positioned to outperform in the new environment, while moving away from securities likely to underperform.
4. What are EIA’s core beliefs or guiding principles that inform its investment decision-making process?
EIA's investment strategy is based on the premise that macroeconomic forces significantly influence the relation between risk factors and security prices. Our macro approach focuses specifically on Federal Reserve monetary policy as implemented through the Fed’s actions on key interest rates. We believe that failure to consider the impact that the monetary environment has on security prices results in systematic mispricing of securities. For example, our research shows that a strategy that targets small, out-of-favor stocks is extremely successful when the Fed is following an expansive monetary policy but underperforms when monetary policy is restrictive. Thus, a smart-beta product that tracks small, out-of-favor stocks underperforms when monetary conditions are restrictive, whereas our strategy reallocates to a superior combination of stocks during that environment. Our strategy is more complex than this simple example as we consider several financial metrics in combination with monetary conditions. Our approach identifies the set of firm metrics that can be used to identify firms that perform best during each of the three alternative monetary environments classified under our approach.
5. Has EIA’s investment philosophy changed over time?
The IFED investment philosophy has not materially changed over time. In effect, by its very nature, it adapts to changing market environments so there is no need to make adjustments to the “philosophy” or methodology. Our philosophy was developed based on over 30 years of peer-reviewed research, in which we determined the most effective method of classifying the monetary environment and the superior set of firm metrics to employ. We believe strongly in the underlying economic basis of our approach. Therefore, the only potential change is a refinement of the model if our continuing research establishes that the inclusion of additional financial metrics improves our security selection process.
6. What makes EIA’s investment philosophy unique and distinguishes it from smart-beta, factor-based, and other types of investment strategies?
The IFED strategy is a unique, active strategy captured in an index format. The strategy is distinctive in the marketplace as it introduces a dynamic dimension to the more traditional static approaches. It is well recognized that traditional strategies, such as smart-beta products, go through extended time periods in which they are "out of favor." Our research establishes that these patterns of inferior performance correspond closely with changes in the monetary environment. Therefore, our strategy shifts portfolio composition such that we target firms with financial metrics that are best positioned to prosper during the existing macro environment. The adaptability of the strategy allows it to identify the optimal set of securities in all market environments and through all market cycles.
7. What is the starting universe of securities for the IFED family of U.S. equity indexes?
The starting universe includes all actively traded U.S. equities. The strategy can be easily modified to accommodate any broad equity market benchmark such as the Russell 3000 or Wilshire 5000 as its initial population. The methodology is also adaptable to subsets of the total US market and can employ the S&P 500, Russell 1000 etc. as starting populations for investors seeking specific exposure to those segments.
8. What is the IFED process for selecting and weighting securities?
In creating our strategy, we developed a monetary policy measure that relies on a combination of Federal Reserve indicators to identify three distinct monetary policy environments – expansive, restrictive and indeterminate. Importantly, our approach distinguishes between actual shifts in Fed policy versus transient changes in interest rates. We applied exhaustive and extensive modeling to identify the critical financial metrics that influence company stock market performance during each of the three environments. There are twelve such metrics; however, the metrics are not common across the three environments. Essentially, the strategy relies on the observation that certain financial metrics have a magnified or “leveraged” effect on companies’ stock prices during particular monetary environments but have little or no effect during other environments. Our process involves weighting those metrics appropriately to take the maximum advantage of the existing monetary environment. Several research analyses, performed by the EIA team and various academic researchers, confirm that the return sensitivities are consistent with the proposed economic rationales for each of the twelve financial metrics. For each environment, the metrics are scored and the population of companies in the universe is ranked based on total metric score. Equities with insufficient liquidity and firms with insufficient financial data to derive the required metrics are eliminated from consideration. In selecting our final sample and conducting the performance evaluation, we apply rigorous academic research standards to eliminate prominent data issues such as survivorship bias, selection bias and look-ahead bias.
9. How do you ensure accuracy of the source data used in compilation of the IFED indexes?
Source data is carefully analyzed and checked for accuracy. The accuracy of our performance statistics are based upon our application of rigorous research standards that control for survivorship bias, selection bias and look-ahead bias. The performance results have been confirmed by independent third parties.
10. Describe internal guidelines and constraints used to manage investment risk of the strategy.
Our strategy relies on twelve different firm metrics to select firms for the portfolio. Due to the unique nature of the metrics, the final set of selected firms have a broad array of financial characteristics. Our tests of style concentration indicate that our strategy results in a portfolio that has a broadly diversified exposure across various risk factors and across industries. In addition, liquidity and diversification concerns dictate that further constraints are warranted for the IFED indexes. For example, IFED-L, which is our first index offering, applies constraints on the weights allocated to individual sectors and individual securities. Furthermore, we can customize our weights to limit exposure to individual firms and industries/sectors per specific client request. For example, we could limit the investment in an individual firm to 4% and place a corridor percentage relative to the S&P 500 for sector weights.
11. Can the IFED methodology be adapted to a population of ESG-rated securities?
The IFED methodology is readily adaptable to a portfolio of ESG screened companies. The same methodology used to arrive at the optimum selection of stocks in a particular economic environment would be applied to a starting population that is ESG screened.
12. How do you monitor and manage index portfolio exposure to the IFED model?
The strategy is a rules-based, transparent and replicable methodology and the model adjusts the portfolio to the current identified macroeconomic environment. The IFED strategy continually scrutinizes firm financial metrics and the economic environment, so our approach, by design, applies significant and continuous portfolio monitoring.
13. Does the IFED index strategy tactically change its factor weighting scheme?
The strategy does not depend on static factor exposures that require the execution of market timing decisions. Instead, we use a set of firm metrics that are employed in combination with three economic environments. The optimal set of financial metrics for each environment is a subset of twelve metrics and is dependent on the existing environment. As a result, the strategy adjusts to the current market environment without the need for decisions on “factor” exposures.
14. How do you decide whether to include or remove a metric or make other changes to your model?
The IFED strategy is a rules-based, transparent, replicable methodology. The underlying premise for the strategy has been researched, tested and refined over 30+ years. We do not foresee any major adjustment to the strategy in the future. If, as a result of additional research, a refinement in the strategy is deemed necessary at some point, the modification will involve adding, eliminating or modifying the weight of a firm metric relative to the current set of twelve metrics. Just as the existing twelve metrics were selected, any new metric would need to be supported by robust academic research by EIA and other external researchers. In addition, the contribution of the metric would be confirmed by back-testing the metric’s influence on performance.
15. Can the strategy be customized? Which aspects are customizable?
The strategy is completely customizable. The IFED methodology assigns an IFED score to each security; securities with relatively high (low) IFED scores are expected to prosper (languish) during prevailing conditions.Therefore, the strategy can be treated as an overlay and used on the total US equity market or any subset thereof, including in combination with ESG screening. With the IFED scores, clients have substantial flexibility to design customized strategies, such as targeting specific types of securities, creating long/short exposures, etc.
16. What is the appropriate benchmark for this strategy?
The IFED Large-Cap US Equity Index™ (IFED-L) should be benchmarked against a large cap US index such as the S&P 500 or Russell 1000. Since the IFED methodology has no required sector or factor exposures, the appropriate benchmark for an IFED index is an index reflecting the respective investment universe.
17. Which factor (style) tilts does this strategy have relative to its benchmark?
Over the long run, the IFED methodology creates a style or factor agnostic portfolio relative to the benchmark. By design, the IFED approach relies on allocating assets such that the portfolio is comprised of firms best positioned to prosper under the existing economic environment. Therefore, the portfolio’s factor exposures are conditional on the existing environment. A shift in the environment corresponds with new holdings that have unique factor exposures.
18. When would the IFED strategy be expected to be "out of favor" or unrewarded?
A unique aspect of the IFED strategy is that it is never "out of favor" with regard to economic conditions. We utilize metrics to identify firms with features that leverage the firms’ exposures to the existing economic environment. When the economic environment shifts, our strategy rotates out of firms comprised of features that are out of favor and rotates into firms that reflect in-favor features. Thus, over time, the strategy produces consistent out-performance.
However, the strategy was designed as a long-run strategy based on established relationships in financial markets. Thus, we do not expect that the strategy will outperform over all short-term periods. The strategy was developed based on the systematic association between the economic conditions and security returns; it relies on the existence of those established patterns. Therefore, when idiosyncratic forces such as a pandemic, a terrorist attack or a financial crisis occur, the systematic patterns can be obfuscated. In general, the strategy was developed based on established relationships that have persisted over 60+ years of financial market history. Idiosyncratic factors may cause short-term disruptions in the strategy's performance, which may persist until normal conditions reemerge.
19. What is the typical range in the number of securities in IFED-L?
Since 1999, the size of the IFED-L portfolio has ranged from 56 to 84 securities with an average of 74 securities.
20. What causes a rebalance in the IFED portfolio and what is the frequency of rebalance?
The strategy is rebalanced for two reasons. First, the index portfolio is rebalanced when there is a signaled shift in monetary conditions. Such a shift requires a major rebalancing to adjust the portfolio so that it reflects the optimal holdings and weights under the new Fed policy environment. Based on our methodology, there is a minimum of three months between rebalancings that occur due to shifts in monetary conditions. For historical perspective, since 1999, about 90% of rebalances have been due to a shift in the monetary environment. The second reason for a rebalance occurs if June is reached with no change in monetary conditions in the prior 6 months. This type of rebalance updates the portfolio based on changes in firm metrics that have occurred during a firm's prior fiscal year. Since 1999, approximately 10% of rebalances were of this type.
21. Can other investment firms replicate the IFED methodology?
Investors may license the IFED methodology to build their own customized active or index investment strategies.
EIA has filed for patent protection for the IFED index methodology as well as copyright protection for the specific algorithms used to create the indexes. EIA has also filed for trademark and tradename protection for the use of the terms IFED, Invest with the Fed and IFED indexes.
22. How effective is the IFED-L methodology in ranking stocks?
The following chart reports performance of the 500 stocks comprising the IFED-L Universe. The stocks are ranked by IFED score, placed in quintiles according to their IFED score and weighted by IFED score. The chart provides strong support for the IFED strategy based on two observations: 1) Four of the five quintiles in the IFED Universe beat the S&P 500, which indicates that weighting by IFED score, rather than market cap, is superior; and 2) The observed monotonic drop in performance across quintiles confirms the model’s ranking efficacy. Quintile 1 to quintile 5 are created based on relative stock ranks that reflect the model’s assessment of stock attractiveness, this ranking is born out in performance.
The IFED-L Universe includes the 500 largest U.S. equities reporting the required scoring data. Note that each quintile in the IFED-L Universe represents the performance of 100 stocks before application of IFED-L’s sector constraints and liquidity filter.
23. Since the IFED methodology relies on Fed policy, how likely is the model to underperform due to poor Fed decision making?
The vast majority of the time, the Fed acts on a proactive basis and has been remarkably effective when doing so. Occasionally, however, Fed actions become reactive (e.g., Lehman collapse, Covid-19). We don’t expect the Fed to be forced to respond reactively often. That said, there will always be outliers, i.e., relatively short periods of time where the market does not price securities consistently with the IFED scoring methodology.
As the evidence in the chart below shows, the IFED-L strategy outperforms substantially when the systematic patterns that the strategy is built around are unimpeded. Note the extremely large positive alphas interspersed throughout the period. A very positive aspect of the IFED-L strategy is that even when Fed policy is implemented less effectively or idiosyncratic forces disrupt model expectations, the IFED-L strategy still avoids significant underperformance. During all monetary environments, the strategy favors firms of high quality, and thus, underperformance is limited even when unexpected developments occur.
24. What type of investor, aggressive or conservative, does IFED-L match most closely?
Given the dynamic nature of the IFED-L strategy and its emphasis on quality stocks, the strategy is equally appealing to both aggressive and conservative investors. As shown in the table below, on average, the strategy is extremely effective in capturing upside market moves, reporting an average upside capture ratio of 136%. This is far and away the best ratio of the major factor indexes and would appeal to investors interested in taking advantage of strong stock market performance. On the other hand, IFED-L limits downside performance when markets suffer because several of its underlying firm metrics represent quality characteristics. Note, that, on average, the strategy captures only 82% of downside movement when markets perform poorly. This compares favorably with the downside capture of the minimum volatility and high dividend indexes; however, these indexes require investors to abandon any strong upside capture aspirations.
The graph below reinforces IFED-L’s ability to capture strong positive moves while limiting underperformance. The graph shows the five worst years in market performance since 1999. During those five years, in three years IFED-L reported positive alphas and in two years it reported negative alphas. The positive alphas ranged from 10.21% to 47.72%, whereas the negative alphas ranged from -1.09% to -1.03%.
25. Does IFED-L performance suffer when monetary conditions are not clearly signaled (i.e., during indeterminate periods)?
No, both the mean (1.58%) and median (0.47%) alpha is positive for the 20 indeterminate periods observed between January 1999 to Dec 2020. In fact, the median alpha for indeterminate periods is slightly higher than for restrictive periods. Other points to note:
Mean and median alpha over the 56 monetary periods are 3.26% and 1.05%, respectively
IFED-L consistently outperforms, with a relatively high incidence of large alphas (positive skewness)
Return distribution is highly positively skewed during expansive and restrictive environments
Return distribution is more symmetric during indeterminate periods
Average duration of a monetary period is 143 days, but has ranged from 22 to 482 days
Indeterminate periods are generally the shortest
Largest positive alphas have generally occurred during restrictive periods and during periods of greater duration
26. Do short-term periods of under performance suggest a weakness in the strategy?
Historically, the drivers of IFED-L's short-term underperformance have been primarily idiosyncratic factors (e.g., financial crisis, trade tensions with China, Covid-19) and do not represent an inherent weakness in the strategy. The IFED strategy relies on systematic monetary-policy-related return patterns confirmed to exist between stocks with certain features. Markets, however, do not always perform predictably or rationally and there are other short-term drivers of returns not captured in the IFED methodology (nor in any model).
Index performance since 1999, and research over longer time frames (back to the 1960’s), confirm that the IFED methodology outperforms over time. The IFED-L approach is particularly effective over longer investment horizons (i.e., 3 years+). To provide additional context for longer term performance, the following table illustrates the percentage of time IFED-L’s rolling average return outperforms the S&P 500 across different periods.