Taking the Discretion out of Factor Selection: The S&P Economic Cycle Factor Rotator Index

Amid the turbulent markets of 2019, the S&P Economic Cycle Factor Rotator Index has been holding steady. The index rotates its allocation between four indices benchmarked to factors—momentum, value, quality, and low volatility—seeking to pick the relevant factor for each phase of the business cycle. The index uses a signal that is based off the Chicago Fed National Activity Index, an economic growth indicator for the U.S. In 2019 alone, the index was allocated to each of the four factors, signaling that the business cycle had some unpredictability, with almost all micro cycles covering a slowdown, expansion, contraction, and recovery.

Historically, the index has regularly cycled through each of the factors in order to adapt to changing market conditions and allocate to the appropriate factor (see Exhibit 1).[1] The most recent allocation switch occurred in June, when the index allocation changed from low volatility to value, indicating that the economy shifted from a period of contraction to one of recovery. The fact that the index remained allocated to value even after rate cuts this year in July and September tells us that this strategy works to guard against significant movements in the market. Despite the market-wide sell-off at the end of 2018, the index has recovered most of the lost value throughout 2019.

In Exhibit 2, we see that, with the exception of last year, the S&P Economic Cycle Factor Rotator Index has not always outperformed its subcomponents. However, by allocating to the different indices, the index maintains a lower risk level while still having the ability to participate in an upward-trending market. As a result, the index achieved higher risk-adjusted returns from September 2009 to September 2019 relative to its sub-components (see Exhibit 3). When we look at the index’s one-year returns, we see that the index and all of its subcomponents had negative returns; value, buyback, low volatility, and momentum had returns of -16.45%, -13.43%, -12.28%, and -2.65%, respectively. It’s evident that the rotation aspect of the index helped protect the index against larger losses, since the S&P Economic Cycle Factor Rotator Index outperformed all of its subcomponents with a return of -2.51% in 2018. Since the index was mostly allocated between buyback and momentum in 2018, we know that the index returns were mainly driven by its momentum component.

By design, the index has a 6% risk control mechanism built in that helps it maintain a constant level of volatility, which in turn enables it to participate in the upside and offer downside protection relative to the S&P 500 Daily Risk Control 5% Index. As seen in Exhibit 4, when compared with the S&P 500 Daily Risk Control 5% Index, we see that the index captured 116% of the upside and 61% of the downside. The capture ratio of 190% shows us that the up-market performance more than compensated for the down-market performance, and that the index outperformed the market overall.

The S&P Economic Cycle Factor Rotator Index has shown that it is effective for adapting to changing market conditions with its ability to allocate to different indices depending on phases of the business cycle. Over the studied period, it not only generated higher returns with lower risk, but also captured more upside and less downside in various market conditions.

[1]   The buyback allocation utilizes the S&P Buyback FCF Index, the dividend index allocation utilizes the S&P 500 Low Volatility High Dividend Index, the value index allocation utilizes the S&P 500 Pure Value, and the momentum strategy utilizes the S&P Momentum United States LargeMidCap.


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