Portfolio Construction Guide During High Valuations

by Vince Lowry, CEO, Global Beta Advisors

One of the great challenges with portfolio construction as we look forward over the next 5 years is the lack of reliable risk models that reflect the realities of today’s investment environment. Never have investors been faced with near zero short-term bond yields as well as the long-term yields below 2% as we now have since the beginning of the COVID-19 global health pandemic. Equally worrisome is the fact that U.S. equity valuations, as measured by price-to-sales within the S&P 500 Index, are exceeding all previous periods. It seems that the old adage of buy low and sell high should be changed to buy high and hope.

Unfortunately, hope is not a strategy. At this point, the development of realistic investment strategies requires the rather blunt realization that the capital market landscape offers lower forward-looking returns.

In our view, traditional bond allocations will no longer be a source of meaningful returns but rather will be a vehicle to: moderate equity volatility, create liquidity and provide a reliable source of capital to meet capital needs during difficult equity markets.

As we think about constructing the fixed income portion of client portfolios in this unusual environment, we believe a high quality 1 to 5-year laddered portfolio of bonds rated single A or better to U.S. treasuries is a prudent approach. With the portfolio structured with weights of 20% in each of the 5 years, this provides a steady incremental supply of maturing capital, allowing investors to redeploy that capital, If interest rates rise. Those maturing bonds in the nearest year could be reinvested farther out on the duration spectrum to take advantage of higher yields. At this point in the secular interest rate cycle, we do not believe there is any reward with incurring interest rate or credit risk.

If we think of investment portfolios purely as a mix of stocks and bonds, the next step in structuring a meaningful portfolio for the next 5 years is to create equity allocation that are centered on owning those equities that demonstrate higher probability of higher relative returns to the broader equity universe.

We believe, at this point in the equity cycle, the easy money has been made. Further, it is our view that valuations of traditional, broad-base, capitalization-weighted index funds have become significantly stretched relative to their historic averages. In plain language, we believe that, on a forward-looking basis, cap weighted index funds offer a highly reduced probability to deliver investors the double-digit returns that they have produced over the previous 10 years. In our estimation, our expected lower forward-looking equity returns, coupled with the likelihood of persistently low interest rates, is likely lead to greater risk taking by investors seeking to replicate the easy lower risk double digit returns of the decade past. We believe, through optimal factor investing, investors can overcome the valuation premiums and enjoy greater returns than broad cap weighted index funds.

We believe there are 5 to 7 identifiable equity factors that drive the returns of the broader equity market. The first research presented to us was by Dr. Gene Fama and Dr. Ken French through their three-factor model, which pioneered a revolution in investment management in the early 1990s. The Fama-French model took years of research to develop through data that could be sorted to run a proper regression analysis to tease out the first known factors. The computing power available today enables deeper research into the efficacy of factor investing. In conjunction with Standard and Poor’s, Global Beta Advisors [GBA] has developed five factors within the U.S. equity markets. These factors are available for investment. The indexes are Global Beta Momentum-Growth Index, Global Beta Low Beta Index, Global Beta Smart Income Index, Global Beta Value Quality Factor Index and Global Beta Size Factor Index.

How does this work?

Global Beta Momentum-Growth Index: while working with the S&P, GBA sorts out both momentum and growth through our proprietary sorting algorithm. The sorting process produces the top 100 companies within the S&P 500 in accordance with revenue growth wherein we believe that the GBA sorted portfolio is very highly correlated to the S&P 500 growth Index. Growth and momentum factors generally have much higher Price to Sales [P/S] ratios than other factors. In fact, as of 06/30/20, the S&P 500 Growth Index has a P/S ratio of 4.31. This is the highest level we have seen in this index in over 20 years. Our proprietary sorting process utilized is not only designed to capture both growth and momentum factors but also capture these factors with lower valuations. This is done by improving the denominator in price-to-sales by identifying companies that are improving their top line sales.

The Global Beta Momentum-Growth Index has performed as expected, particularly during the 2020 first quarter collapse in the global equity markets. The Index was down -12.88% for the first quarter versus -19.60% for the S&P 500 Index and -14.50% for the S&P 500 Growth Index1. Based on our research, we believe that our Index has performed exceptionally well in low growth, low inflation environments. We believe that our Index should be considered as an overweight position during periods of low growth expectations. Our research has shown companies that grow their revenues faster than an environment of slow growth are often rewarded higher forward-looking returns. During the most recent downturn in the market, investors seemed to be treating large cap growth companies with little to no debt as long bond proxies. Our index returns reflect this activity as well.

Global Beta Low Beta Index: GBA sorts the S&P 500 index by identifying the equites that have experienced the lowest Beta over the past year. In order to avoid the non-economic premium built into low volatility strategies during the past decade, GBA created an economic weighting system in our low volatility index. The goal is to produce an investment strategy with exposure to low beta securities with better valuations. The index returns have performed as expected in both up and down markets. During the past decade, several investment products utilizing low volatility strategies have discovered, during the most recent market downfall, that they owned a portfolio of stocks with similar volatility to the broad market. Consequently, over the past decade, low volatility products developed a price-to-sales valuation in line with the broad market. We believe this valuation bubble in low volatility is the direct reason for their disappointing downside during the first quarter of 2020.

Global Beta Smart Income Index: GBA sorts the S&P 900 for dividend paying companies. The Index expands into the S&P 900 to take advantage of strong dividend payers outside the large cap universe. GBA seeks to diversify over all sectors. This is done by selecting what GBA believes to be the strongest dividend paying securities, captured over the previous four quarter cycled, and then diversified by Global Industry Classification Standard (GICs) sector. We believe energy stocks are very strong dividend payers, we insert a safety valve by capping the energy sector to 3% during periods where crude oil prices fall below its 30-day moving average. We believe that this index provides a strong exposure to yield. The Index is economically weighted to provide lower valuations compared to its competitors. GBA Believes that yield stocks become very attractive during low interest rate environments as investors find alternative opportunities for yield, which can lead to those securities being overvalued. Our goal is to maintain lower valuations as measured by price-to-sales ratios.

GBA believes our three index strategies will provide a broad exposure to many of the relevant factors we mentioned above. The professional and non-professional investors will find the index strategies as a means to avoid the very crowded trades of cap weighted indexes.

Important Disclosures
Global Beta Advisors (“Global Beta”)
The Global Beta Indexes used in the Global Beta Program include:

  • Global Beta Quality-Value Index (“Quality-Value Index”)
  • Global Beta Growth-Momentum Factor Index (“Growth-Momentum Factor Index”)
  • Global Beta Low Beta Index (“Low Beta Index”)
  • Global Beta Mid-Small Index (“Mid-Small Index”)
  • Global Beta All Cap Multi-Factor Index (“All Cap Multi-Factor Index”)
  • Global Beta Large Cap Multi-Factor Index (“Large Cap Multi-Factor Index”)
  • Global Beta ETF Rotation Model (“ETF Rotation Model”)
  • Collectively (the “Global Beta Indices and ETF Rotation Model”)

Certain information provided on the Global Beta website is based on third-party sources which information, although believed to be accurate, has not been independently verified. Global Beta assumes no liability for errors and omissions in the information contained herein. This website information is provided for informational purposes only.

Forward Looking Statements
The presentations included on this website may contain “forward-looking statements” which are based on Global Beta’s beliefs, as well as on a number of assumptions concerning future events, based on information currently available to Global Beta. Current and prospective clients are cautioned not to put undue reliance on such forward-looking statements, which are not a guarantee of future performance, and are subject to a number of uncertainties and other factors, many of which are outside Global Beta’s control, which could cause actual results to differ materially from such statements. Any forward-looking statements speak only as of the date they are made and Global Beta assumes no duty to and does not undertake to update forward-looking statements.

Hypothetical Performance
The performance results included in this presentation are hypothetical returns which have been compiled by Global Beta. The performance results are based upon a hypothetical model. Hypothetical performance results may have inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. One of the limitations of hypothetical performance results is that they are prepared with the benefit of hindsight. There are numerous other factors related to the markets in general or to the implementation of any specific trading strategy which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results. These returns should not be considered as indicative of the skills of the investment adviser.

Performance Results Presented Net of Fees
The Global Beta website contains net-of-fees returns of the Global Beta Indices and ETF Rotation Model that are managed in accordance with Global Beta’s investment strategy. The net-of-fees returns reflect the deduction of a model annual investment management fee of 0.20% and other fees (such as brokerage commissions) which collectively reduce returns. The net-of-fee returns reflect the reinvestment of dividends and other earnings. Performance results will vary based upon when an investor would have invested during the period measured, and past performance is not indicative of future results.

Benchmark Definitions and Disclosures
S&P 500 Value
We measure value stocks using three factors: the ratios of book value, earnings, and sales to price. S&P Style Indices divide the complete market capitalization of each parent index into growth and value segments. Constituents are drawn from the S&P 500®.

S&P 500 Growth
We measure growth stocks using three factors: sales growth, the ratio of earnings change to price, and momentum. S&P Style Indices divide the complete market capitalization of each parent index into growth and value segments. Constituents are drawn from the S&P 500®.

All-Cap Add S&P Composite 1500
The S&P Composite 1500® combines three leading indices, the S&P 500®, the S&P MidCap 400®, and the S&P SmallCap 600®, to cover approximately 90% of U.S. market capitalization. It is designed for investors seeking to replicate the performance of the U.S. equity market or benchmark against a representative universe of tradable stocks.

For the Large Cap Multi Factor, Value-Quality, Momentum Growth, and Low Beta Indices:
The S&P 500® Index is a free-float market capitalization weighted index that includes a representative sample of 500 leading companies in leading industries of the U.S. economy focusing on the large-cap segment of the market, with over 80% coverage of U.S. equities.  Its ticker symbol is SPX.

For the Mid-Small Size Index:
The S&P SmallCap 600™ Index is a capitalization-weighted index designed to be an efficient portfolio of U.S. small-cap companies that meet specific inclusion criteria to ensure that they are investable and financially viable.  The Index covers approximately 3% of the U.S. equities market.  Its ticker symbol is SML

For All Cap Multi-Factor:
The S&P 1500® is a broad market capitalization-weighted U.S. equity index that combines three leading indices, the S&P 500®, the S&P MidCap 400®, and the S&P SmallCap 600®.  Thus, the S&P 1500 Index includes the top large cap, mid cap and small cap stocks and covers approximately 90% of the U.S. market.  Its ticker symbol is SPR

For the ETF Rotation Model
A blended benchmark of 80% iShares MSCI All Country World Index ETF, 20% iShares Barclays Aggregate ETF.
You cannot invest directly in an index, which also does not take into account trading commissions and costs. The volatility of the indices may be materially different from the performance of the Global Beta Indices or ETF Rotation Model.  The S&P 500, S&P 600, S&P 1500 Index information and the blended benchmark are included merely to show the general trend in the broad and small [and mid-] cap markets for the periods indicated and are not intended to imply that any portfolio [Global Beta Indices or the ETF Rotation Model] is similar to an index either in composition or element of risk. The indices are unmanaged and an investment cannot be made directly into the indices or the blended benchmark presented.

Marks Dow Jones® and S&P® are trademarks of Dow Jones Trademark Holdings, LLC and Standard & Poor’s Financial Services, LLC, respectively, and the mark “Calculated by S&P Dow Jones Indices” has been licensed for use by Global Beta Advisors and sublicensed to Global Beta Advisors in connection with the management of clients’ assets that are invested in the Global Beta Program.

Past performance is no guarantee of future results.

Global Beta Smart Income Index: composed of stocks in the S&P 900 with the highest average 12-month trailing dividend yield over the prior 4 quarters on a diversified basis.

The S&P 900 combines the S&P 500® and the S&P MidCap 400® to form an investable benchmark for the mid- to large-cap segment of the U.S. equity market.

1: Data is from Factset Research Systems