Why You Should “Invest with the Fed”: As at May 31, 2022

The Federal Reserve has been front and center in virtually all recent investment discussions. The crucial role that Fed policy plays in security performance is recognized by investment professionals and novice investors alike; however, incorporating Fed policy in an effective investment strategy has largely alluded even the most astute investment professionals. Based on over 30 years of academic research, EIA’s founders designed the Invest with the Fed (IFED) strategy to integrate Fed policy into an investable strategy.

The team at EIA has a proven track record of designing index strategies that rely on Federal Reserve policy signals to optimally guide portfolio composition. The IFED approach is an active, rules-based method that rebalances its indexes approximately twice per year to maintain a composition that aligns with market conditions, and thus, IFED indexes avoid applying an investment style that has become out-of-favor.

On June 9th, 2020, EIA launched the IFED-L index as a customized, large cap U.S. equity index. IFED-L selects stocks from the largest 500 U.S. equities and applies various specified constraints on its holdings. On September 14, 2021, UBS launched two Exchange Traded Notes (ETNs) on the New York Stock Exchange that track IFED-L. The success of IFED-L is demonstrated by its post-launch performance, which is illustrated in the following chart.

Exhibit 1: IFED-L and S&P 500 Recent Performance (through May 31, 2022)

Since its launch in June of 2020, IFED-L has returned 57.16% versus 32.66% for the S&P 500. Adding to the robustness of this result, the superior performance was generated over a period that witnessed several historic events including a global pandemic, Russia’s invasion of Ukraine, major supply chain disruptions, and a return to historically high inflation rates. IFED-L’s persistent outperformance promotes the soundness of the IFED strategy design.

EIA's All-Cap Index (IFED-A)

In this commentary, we feature the IFED-A index, which is an all-cap U.S. equity index with components selected from the 1,500 largest U.S. equities. The methodology underlying IFED-A, and EIA’s other non-customized IFED indexes, relies on two fundamental components as follows:

it uses 12 firm-specific financial metrics to select 75 stocks with the highest IFED scores, and therefore, it selects the stocks best positioned to prosper during the prevailing market environment,
it weights those 75 stocks according to their IFED score (i.e., their ability to benefit from prevailing market conditions).

The following chart depicts the efficacy of the IFED methodology applied to the largest 1,500 U.S. stocks over the period Jan 1999 through May 2022. The 1,500 stocks are ranked by IFED score, placed in quintiles according to their IFED score and weighted by IFED score within each quintile/portfolio.

Exhibit 2: Performance of IFED Quintiles

The chart supports the IFED strategy’s effectiveness based on two observations:

Four of the five quintiles beat the S&P 1500, which indicates that weighting by IFED score, rather than market cap, produced superior performance, and,
The observed monotonic drop in performance across quintiles confirms the effectiveness of the IFED model’s ranking methodology. Quintile 1 to quintile 5 are created based on IFED Scores that reflect the model’s assessment of stock attractiveness for the prevailing market environment; the IFED ranking is born out in performance.

IFED-A is composed of the 75 stocks with the highest IFED Scores, which are stocks included in Quintile 1. EIA constructs several additional indexes defined by market capitalization and investment style following the same approach. Click here to view EIA’s other index offerings.

The IFED strategy is designed to capture established relationships between monetary policy signals, market conditions and security return patterns. Therefore, the strategy is best judged based on its long-term performance. The following chart reports back-tested performance for IFED-A and its benchmark (the S&P 1500) for various long-term periods through May 2022.

Exhibit 3: IFED-A and S&P 1500 Long-Term Back-Tested Average Annual Performance

IFED-A’s outperformance (alpha) of 12.65% per year since 1999 supports the long-term viability of the IFED strategy. The time-series of alphas is depicted more clearly in the following graph. The graph shows rolling 5-year average annual alphas for IFED-A from 1999 through May 2022.

Exhibit 4: IFED-A Rolling, 5-Year Average Annual Alphas

The time-series of rolling 5-year average annual alphas supports the consistency of IFED-A’s outperformance. Remarkably, throughout the entire period, IFED-A produced superior performance, relative to the U.S. market, in 100% of cases. Furthermore, the level of outperformance is shown to rebound substantially after each lull in relative outperformance. Finally, small annual alphas (below 3%) occur infrequently and are overwhelmed by the frequency and size of the large alphas (above 5%).

Overall, we believe that the Fed provides a roadmap that can be used to successfully guide portfolio composition. The challenge facing investors is identifying a strategy that can effectively read and interpret the various road signs along the way.

About EIA

Economic Index Associates (EIA) is a developer and licensor of active index strategies that are replicable, investable, rules-based and transparent.

EIA’s three founders (Robert Johnson, Gerald Jensen and Luis Garcia-Feijoo) are the authorities on the association of Fed monetary policy with security returns – combined they have published over 200 academic articles, which have over 10,000 citations. The basic premise of their original research is captured in their book - Invest with the Fed (McGraw-Hill, 2015).

Leveraging its founders’ extensive research, the “Invest with the Fed” (IFED) methodology uses Fed policy signals and firm fundamentals to guide stock selection. The IFED strategy is a dynamic approach that selects portfolios that align with whatever market environment is signaled by Federal Reserve policy actions.

For further information please visit our website.