Quality Equity Factor Takes Lead In 2019 As Small Caps Stumble

Last Friday’s sharp market slide rattled investor sentiment, but by the standard of US equity factor ETFs the positive year-to-date trend remains intact across the board.

As of yesterday’s close (Mar. 25), all the major factor strategies are positing solid gains for 2019, based on a set of exchange-traded funds. But a closer review of price action over the past month reveals a leadership change.

Leading the field at the moment for year-to-date results: iShares Edge MSCI USA Quality Factor (QUAL), which targets companies with “healthy” balance sheets, is up a strong 13.9% so far in 2019. In close pursuit via a second-place year-to-date run: large-cap growth shares by way of iShares S&P 500 Growth (IVW), which is ahead by 13.5% this year.

On both counts, the funds are moderately ahead of the broad market, based on the SPDR S&P 500’s 12.1% increase this year.

Meanwhile, the formerly leading performance of small-cap value has taken a back seat in the current year-to-date score. A month earlier earlier, iShares S&P Small-Cap 600 Value (IJS) was the top factor performer; at the moment, IJS has receded to the lower half of year-to-date results. In fact, small-cap strategies generally have fallen behind in relative terms after leading the market earlier in the year.

Frank Cappelleri, executive director at Instinet, wrote earlier in March that “small-caps remain a very key component of the market’s comeback story. Seeing demand reignite in the most speculative names would give us a strong indication that the bid can continue. And vice versa.”

Small caps are still posting respectable gains year-to-date results, but Cappeleri’s vice versa observation has come into play. Indeed, the recent weakness in small-cap momentum in recent weeks suggests these stocks are heading into a less-forgiving market climate.

Consider, for example, how iShares S&P Small-Cap 600 Value (IJS) compares with the current year-to-date leader — iShares Edge MSCI USA Quality Factor (QUAL). Roughly a month ago, the bull run for IJS hit turbulence while QUAL continued to rally. It could be noise, of course, but for the moment there’s a bit of doubt on whether small caps can regain their luster.

Some analysts have turned cautious on small caps via the reasoning that the slowdown in economic growth will favor larger firms. Richard Turnill, BlackRock Global’s chief investment strategist, made this case a few weeks back, writing:

Global small cap stocks have had a strong 2019 so far, outperforming large caps by more than three percentage points. This is not a rally worth chasing, in our view. As the pace of the global expansion slows, we prefer large cap equities. We favor exposures to firms with quality markers such as strong balance sheets.

A few weeks on, the crowd seems to agree, or so it appears based on the recent leadership change in factor ETFs that put iShares Edge MSCI USA Quality Factor (QUAL) in the lead and trimmed the sails for several small-cap funds.