The Nasdaq IFED-L index has shown consistent outperformance over four years of varied market conditions, achieving a 19.65% annual return versus the S&P 500's 15.20%. The use of Federal Reserve policy signals to adjust stock selection has proven superior to static investment and factor strategies. The IFED strategy's robust results and lower downside risk validate its effectiveness and has led to increased investor interest and the launch of additional investment products based on IFED indexes.
One year of outperformance is nice, two years is impressive, three years is a pattern, and four years is both proof of concept and validation. The EIA team has achieved 4-years of outperformance as Nasdaq IFED-L returned an annual return of 19.65% versus 15.20% for the S&P 500. Total returns for Nasdaq IFED-L since its launch are shown in Exhibit 1 below.
Exhibit 1. Nasdaq IFED-L Total Return Since Launch, 6/9/2020-6/8/2024
A traditional gift for a four-year anniversary is flowers, indicating a relationship in full bloom. This commentary provides evidence that the IFED strategy is in full bloom - consistent with the findings of our 30+ years of peer reviewed research.
The Nasdaq IFED-L index represents EIA’s first customized index, which was launched on June 9, 2020. The index is a large-cap, US equity index that, as with all IFED indexes, applies the IFED strategy. The IFED strategy relies on 12 firm financial metrics to select stocks that are optimally positioned to prosper in the market environment identified by the IFED indicator. The IFED indicator assesses Fed policy signals to identify impending shifts in market conditions and classify conditions into one of three environments, expansive, restrictive, or indeterminate. The current classification is restrictive, which indicates that the Fed is prioritizing price stability over the other aspect of its dual mandate, full employment.
The IFED strategy grew out of a 30+ year research program that was designed exclusively to achieve tenure and acclaim within the academic community. We never envisioned that our findings would reach investment professionals and those professionals would ultimately convince us that we should develop the IFED strategy for commercial use.
The basic premise of the IFED strategy is that the optimal investment style depends on market conditions. The strategy advocates that the best stocks to hold when the biggest concern is inflation are very different from the optimal stocks when concerns about economic weakness dominate. In other words, the risk factors that drive stock returns adjust with shifts in the market environment, which explains why the various investment styles go in- and out-of-favor. The IFED strategy avoids that boom-and-bust cycle by reallocating portfolio holdings when an impending shift in market conditions is signaled.
Our research demonstrates that using Fed policy actions to classify market conditions is superior to other approaches. The rationale for such a conclusion is that the Fed controls interest rates and the money supply. Furthermore, the Fed shifts policy based on its “expectations” regarding inflation and economic activity. Thus, the IFED strategy incorporates a forward-looking mechanism that considers impending conditions in the economy. How can any indicator improve on that? Ultimately however, the proof is in the pudding, as they say. Does the strategy work, and more importantly, will it continue to work in the future?
The Back-Test Results are Great, How About the Future?
When we began promoting the IFED strategy, prospective clients were impressed with the alpha, however, some questioned the strategy’s future viability. Common responses included, “Anyone can develop a strategy that will work in the past,” and “Federal Reserve operating procedures are different now from before.” The past four years have served to address these concerns and further validate the IFED strategy.
The past four years represent a perfect period to establish the viability of an investment strategy. During this period, we witnessed a huge variety of conditions and events including a pandemic, a very accommodative Fed monetary policy followed by the application of a restrictive policy, two strong bull markets, one severe bear market, and substantial variation in inflation and interest rates. It is hard to imagine a better proving ground for an investment strategy.
Exhibit 2 reports additional performance results for Nasdaq IFED-L over its 4-year live period and for the full period of analysis, which runs from January 1999 through June 8, 2024. The last five rows of the table report data regarding the consistency of IFED strategy outperformance. The values in the final four rows are derived by rolling returns forward one month at a time.
Exhibit 2. Nasdaq IFED-L Performance, Pre- and Post-Launch
On July 19, 2022, EIA launched its second index, Nasdaq IFED-LV, which is a large-cap, low volatility US equity index. In selecting and weighting stocks, the index applies the IFED strategy to a low volatility universe of large-cap US equities. The performance results for Nasdaq IFED-LV are presented in Exhibit 3.
Exhibit 3. Nasdaq IFED-LV Performance, Pre- and Post-Launch
The levels of outperformance (alpha) reported in Exhibits 2 and 3 confirm the effectiveness of the IFED strategy. Large positive annual alphas are reported for the live period (IFED-L = 4.45% and IFED-LV = 7.56%) and for the full period (IFED-L = 7.05% and IFED-LV = 3.90%), which establishes proof of concept for the strategy. The size and similarity in outperformance across both periods and indexes strongly support the robustness of the strategy.
The consistency of outperformance, as demonstrated in the last rows of each exhibit, confirms that the IFED strategy captures a systematic pattern in returns, which is achieved more effectively as the holding period lengthens. For both indexes, outperformance has occurred more than 82% of the time when the holding period extends to three years or more. For shorter term periods, outperformance occurs approximately 60 to 70% of the time. Thus, the EIA team advocates the IFED strategy as a long-term, buy-and-hold approach and cautions clients to expect short-term periods of underperformance.
The Alpha is Great, but the Tracking Risk is High
The IFED strategy represents a hybrid investment approach that combines top-down along with bottom-up aspects as well as incorporating both active and passive components. The strategy uses Fed policy signals to guide overall stock selection, which considers 12 firm-specific financial metrics, thus combining the top-down and bottom-up approaches. The strategy’s passive element is that it applies a rules-based quantitative methodology to portfolio formation, whereas it is active in that portfolio composition changes when the holdings no longer align with the market environment i.e., economic conditions.
Volatility based risk measures such as tracking risk and standard deviation are most applicable when the return distribution is symmetric. In other words, such risk measures are most appropriate when the strategy or manager is judged in advance as offering limited skill in portfolio selection. In contrast, for investment approaches that contain active elements, the more appropriate consideration is downside risk. That is, what is the probability of falling short of the investor’s objective or benchmark? No investor worries that returns may far exceed their goal, yet volatility-based measures record such occurrences as large negatives.
EIA’s IFED strategy is designed to capture alpha based on established, long-term return patterns, which requires the IFED portfolios to diverge from the typical market-cap weighted index. Therefore, tracking error and short periods of underperformance are expected as markets adjust to changes in economic conditions and the return drivers adapt. To examine the time-series performance of the IFED strategy, Exhibit 4 shows rolling 6-month alphas for Nasdaq IFED-L and Nasdaq IFED-LV since 1999.
Exhibit 4. Rolling 6-Month Alphas, Nasdaq IFED-L and Nasdaq IFED-LV, 1999-6/8/2024
The plots in Exhibit 4 correspond with the IFED strategy design, which is to prosper when normal return patterns prevail, while avoiding significant underperformance when unusual return drivers dominate. Note that the underperformance levels are small and relatively short-lived in comparison to the outperformance. In addition, the periods of underperformance are typically followed by periods of substantial outperformance. These observations align with EIA’s research showing that the return patterns underlying the IFED strategy are occasionally obscured by unusual events or irrational investor pricing; however, normal patterns are ultimately restored after short transition periods. Finally, note that the alphas are not concentrated in any time frame--large positive alphas are observed throughout the 24+ year period.
As noted previously, the risk of active strategies is most appropriately assessed via downside risk measures. Exhibit 5 presents risk statistics for Nasdaq IFED-L and Nasdaq IFED-LV for each index’s live period and full period. Note that Nasdaq IFED-LV starts with a constrained investment set of low-risk stocks, which obscures the risk choice mechanism of the IFED strategy. Thus, we focus our discussion on Nasdaq IFED-L, which selects stocks from across the risk spectrum.
Exhibit 5. Nasdaq IFED-L and Nasdaq IFED-LV Risk Statistics
The IFED strategy is designed to prosper when normal return patterns prevail by aligning portfolio constituents with impending market conditions. The strategy’s success in this regard is reflected by the upside capture values reported in Exhibit 5. In both the live period and full period, Nasdaq IFED-L captures far more of the market upside relative to market downside - capturing over 30% more of the market upside relative to downside.
Regarding downside risk, the data indicates that much of Nasdaq IFED-L’s standard deviation and tracking risk is due to upside deviation, i.e., abnormal strong performance. In the live period, upside deviation is over 50% higher than downside deviation and in the full period the difference is nearly 20%. Thus, the total volatility measures present an upwardly biased indication of the true risk inherent in the IFED strategy.
The IFED strategy incorporates several features to alleviate downside risk and avoid introducing a reliance on speculative elements:
the strategy always remains fully invested in equities. The strategy shifts allocation across equities to maintain an optimal alignment between portfolio holdings and market conditions. Thus, the strategy is not a speculative market timing approach.
the 12 financial metrics used in selecting portfolio constituents include several quality measures. The strategy favors stocks with financial strength and stability. Hence, when unusual factors drive security returns, such as a pandemic or financial crisis, the strategy does not suffer abnormally.
the strategy shifts holdings when market conditions change to avoid going out-of-favor. The substantial underperformance experienced by value and growth investors is readily apparent as these static strategies experience the extreme boom-and-bust cycles over time.
the strategy selects stocks based on firm fundamentals, and thus, avoids emotional considerations and investor euphoria when selecting stocks. The IFED strategy typically underweights glamour stocks such as the magnificent mega caps, whose prices reflect a significant speculative component. Investor emotion and euphoria can shift quickly producing large losses as quickly as gains. The magnificent mega caps have dominated market performance over the past four years, which explains the difference in capture levels between the live and full periods. Specifically, the IFED strategy tends to underweight glamour stocks, which have driven market returns in recent years.
The downside risk measures reported in Exhibit 5 confirm that the strategy effectively avoids the extreme underperformance that tends to plague most active investment strategies, and particularly those that are factor based. The factor-based strategies become extremely popular when their underlying style is in-favor; however, the strategies substantially underperform when they go out-of-favor. In contrast, the IFED strategy is designed to avoid going out-of-favor.
Exhibit 6 reports long-term performance through May 2024 for the IFED strategy relative to several prominent factor strategies. Nasdaq IFED-L is presented in the top panel relative to several general factor indexes, whereas Nasdaq IFED-LV is included in the lower panel with several low risk factor indexes.
Exhibit 6: Nasdaq IFED-L & IFED-LV Long-term Relative Performance (thru May 2024)
The returns reported in Exhibit 6 establish the superiority of performance that the IFED indexes have demonstrated over their competitors over time. Nasdaq IFED-L beat all the alternative indexes in all periods exceeding 3 years and beat all but one index (Momentum) in the 1 and 3-year periods. Similarly, Nasdaq IFED-LV beat its competition in all periods exceeding 1 year and fell short of only the S&P 500 High Dividend index in the 1-year period. The consistency of superior performance across indexes and time periods provides strong validation for the efficacy of the IFED strategy.
The IFED Strategy and the Magnificent Mega-Caps, A Final Word
During most of its live period, Nasdaq IFED-L has contended with the performance of the magnificent mega caps. Occasionally, when their fundamentals were attractive, the IFED strategy selected a few of the magnificent members. Typically, however, these glamour firms were either not represented or vastly under-represented in the IFED portfolios. Given this observation, it is impressive that the IFED indexes have outperformed their benchmarks over the last few years.
Exhibit 7 reports returns for the Magnificent 7 and Nasdaq IFED-L during Nasdaq IFED-L’s live period.
Exhibit 7 Nasdaq IFED-L Relative Performance Post Launch, 6/9/2020 – 6/8/2024
The returns indicate that this period was truly remarkable for the seven glamour firms comprising the Magnificent 7 as they produced an annual return of nearly 25%. The returns, however, corresponded with substantial levels of total risk and downside risk. With respect to the risk-adjusted measures, Sharpe ratio and Sortino ratio[1], Nasdaq IFED-L clearly dominated both the S&P 500 and the Magnificent 7. Furthermore, total risk and downside risk for the Magnificent 7 far exceeded that of the market and Nasdaq IFED-L, which should trouble most investors.
Investors that are confident that the Magnificent 7 can continue to generate similar returns going forward should target portfolios heavily weighted toward the seven glamour stocks. It is worth remembering, however, the iterations that have come before the Magnificent 7, i.e., FANG→FAANG→FAANGM→Magnificent 7. How confident should investors be that the next iteration will comprise the same constituents?
In general, the IFED strategy avoids chasing fads, and instead relies on a sound investment methodology based on firm financial data and the impending economic and monetary environment. The strategy occasionally misses some investment "unicorns", but the strong historical performance over a long history of varying macro conditions suggests that the steadier, empirically motivated approach underlying the strategy tends to win out in the end.
Fortunately, a question we have been hearing with increasing frequency is, “How can I invest in the IFED strategy.” For prospective investors, UBS has: i) launched two NYSE listed exchange traded notes (ETNs) that track Nasdaq IFED-L, and has ii) begun issuing structured notes over a 10% target volatility version of Nasdaq IFED-LV.
[1] The Sortino ratio measures risk as downside deviation from 0, whereas the Sharpe ratio measures risk as standard deviation.
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