As we wrap up the 1st quarter of 2021, we’re seeing a distinct changing of the guard. Where 2019 and 2020 were dominated by large-caps and growth stocks, 2021 has seen a resurrection for small-caps and value stocks. The COVID pandemic has also led investors to seek out some safer alternatives instead of reaching for growth at all costs.
After lagging for several years, value stocks are finally making a comeback. Value stocks, in general, tend to outperform during recovery periods, but the overweights in energy and financial stocks are particularly helpful. After the oil crash in April that happened in response to the COVID shutdowns, oil prices have fully recovered and are now pricing in surge in energy demand expected for later this year. Interest rates have also risen significantly, which has improved the prospects for banks to lend profitably.
Small-caps have also had a nice run of their own lately, also betting on an economic rebound and trillions of dollars of stimulus and loans designed to help smaller businesses survive the downturn. As long as the recovery narrative remains intact, the value/small-cap outperformance trend could continue, although weakness in the jobs market and an excessive dependence on central bank intervention has the potential for causing trouble.
Looking at ETF factor returns in 2021, we can clearly see these trends playing out.
Value has been the clear winner, returning nearly 20% in just the first quarter. Small-cap outperformance can be seen in the size factor ETF, which is up more than 9% year-to-date.
Another ancillary beneficiary of this pivot has been the quality factor. The sudden COVID bear market of 2020, which disproportionately impacted those companies with poor balance sheets and high debt loads, caused investors to seek out stocks backed by healthier cash flows and steadier profits. That’s led to comparatively above average returns in 2021, but quality has been a sneaky good performer over the past three years as well.
The surprise on this list might be the momentum factor. For a while, it was the only factor that was beating the market thanks to its overweight in tech and growth stocks. That tilt, however, has worked against it in 2021. This ETF is still nearly 3/4 invested in the combination of tech, communication services and consumer discretionary sectors. With the market having favored cyclical and value stocks recently (and considering the fund’s infrequent rebalancing schedule), that overexposure has been an anchor and led to it easily being the worst performer.
Looking at ETF flows, investors haven’t fully given up on momentum stocks, but the market’s latest trends have shown up in where investors are putting their money.
Low volatility stocks have seen huge outflows as investors bet heavily on recovery plays. Value is the only factor that ETF investors have been betting heavily on this year. Quality has seen $3 billion in outflows in 2021. Even the size factor has seen outflows despite its strong returns recently.
Since investor activity tends to follow performance, I’d expect value to continue attracting dollars. I think small-caps could catch up, although other small-cap ETFs are also experiencing relatively tepid interest. If the latest run hasn’t sparked a great deal of interest, it may be a while before it draws more significant interest.
Momentum will be the one to watch. The ETF only rebalances twice annually in May and November. It will retain its tech/growth tilt for at least another month, so the performance will depend on whether cyclicals remain in favor. Once the rebalance date passes, it may look more heavily tilted towards cyclicals and value, but it could be an underperforming ride until then.