Understanding the dynamics of investment factors and exchange-traded funds performance in the U.S. market 2018-2022

Abstract

The increasing popularity of exchange-traded funds (ETFs) among retail and professional investors necessitates a deeper understanding of their value-creation process. Recognizing inconsistencies between stated investment strategies and portfolio exposures is crucial for appropriate rebalancing in accordance with investment policy statements. Against the backdrop of evolving investment factors during the pandemic and changing geopolitical circumstances, the performance of ETFs has undergone significant shifts. Analyzing the directional changes of prevailing investment factors within specific macro environments is essential for optimizing portfolios composed out of ETFs. This study has a dual objective: firstly, to comprehend the dominant investment factors and their dynamics in the U.S. market, and secondly, to evaluate the performance of ETFs that adhere to specific investment philosophies and strategies. To achieve these objectives, the Fama-French three and five-factor models were employed to analyze a dataset comprising 72 U.S. ETFs. These ETFs were then categorized into four portfolios based on investment style and size. Performance appraisal measures were utilized to compare portfolios on a risk-adjusted basis relative to the benchmark. The bear market that commenced in early 2022 had a universally negative impact on observed ETFs due to their longonly exposures. This inflection point also marked a shift in the relative performance between value and growth styles, as well as the outperformance of more conservative investing approaches, underscoring the importance of adapting to changing market conditions. Additionally, the absence of a size premium throughout the observed period confirms investors' preference for large-cap stocks as a resilient factor. Furthermore, the size effect exerted a universal negative influence due to the size drift of ETFs employing a stated large-size investment strategy. During the observed period, the value style experienced a significant recovery, characterized by higher book-to-price ratios, operating profits, and more conservative investment policies that produced superior results compared to the previous longer period. The findings of this research enhance our understanding of the influence of investment factors on U.S. ETF performance, providing valuable insights for investors and portfolio managers who may need to adjust their strategies in response to observed changes in market dynamics.