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Smart beta and interest rate rises: What would have happened last time?

By: Tom Goodwin, Senior Research Director

With the growing interest in smart beta against the backdrop of a looming interest rate rise expected from the Federal Reserve Bank (the “Fed”), many investors are wondering how these indexes might respond to a rate increase. Factor indexes—designed to capture the systematic return to a specific set of company characteristics—are of particular interest, given that few of them were around when the Fed raised rates in the past. In this blog post, we aim to shed some light on the consequences for smart beta by looking at simulated returns for six FTSE Russell factor indexes during the last sustained period of rising rates.

Let's take a look at the 2004 – 2007 period, when the Fed began a restrictive stance to monetary policy that led to a steady rise of the Fed Funds Rate from 1% in June 2004 to a peak of 5.26% in July 2007.

The chart above plots six simulated FTSE Russell factor indexes over this time period. The factors are momentum, illiquidity, quality, size, value and volatility.1 The returns are expressed in the form of the growth of $1 over the FTSE USA index broad benchmark.This is equivalent to cumulative excess returns over the FTSE USA index broad benchmark. Excess returns were chosen as they effectively back out common market movements that might otherwise obscure differences between the factor indexes.

The chart reveals a distinct bifurcation of the six indexes into two groups of three. One group consists of the value, illiquidity and size factor indexes which would have steadily outperformed the FTSE USA index broad benchmark during the period of monetary tightening. The second group consists of the quality, momentum and volatility indexes which would have been essentially flat against the broad benchmark during this period.

The table below shows what the compound excess returns to the six factor indexes would have been over the period of monetary tightening. It confirms what the chart shows, namely the substantial outperformance of value, illiquidity and size versus the broad benchmark-like performance of momentum, quality and volatility during this period.

It’s important to note, by the way, that these are simulated returns and that correlation is not causation, so one should exercise caution in interpreting these results. Nonetheless, as factor indexes have grown in popularity these illustrations hopefully provide an interesting perspective on an important issue.

 

[1] Reference here to relevant FTSE documentation explaining these indexes.

 

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