{"id":224770,"date":"2025-05-29T10:45:00","date_gmt":"2025-05-29T14:45:00","guid":{"rendered":"https:\/\/ibkrcampus.com\/campus\/?p=224770"},"modified":"2025-05-30T03:48:07","modified_gmt":"2025-05-30T07:48:07","slug":"inflection-points-rethinking-your-core","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.com\/campus\/traders-insight\/securities\/macro\/inflection-points-rethinking-your-core\/","title":{"rendered":"Inflection Points: Rethinking Your Core"},"content":{"rendered":"\n

Financial markets seem to be embracing a sense of relief and normalcy with the global trade conflict on hold, despite U.S. tariffs at around 10% on most trading partners and 30% on China.1<\/sup> Markets welcomed the 90-day tariff pause with China and now await further clarity on negotiations, along with updates on U.S. tax and spending policy.<\/em><\/p>\n\n\n\n

In the meantime, the next few weeks and months will likely be about assessing the short- and medium-term damage weighing on consumer and business sentiment, creating a potential drag on the economy.2<\/sup> Economists have been revising down U.S. growth estimates, but as we noted in Trying to Reason with High Vol Season this is a policy-induced slowdown that may be reversed.3<\/sup> The next revision to estimates may even be higher, but a clear verdict is a long way off.<\/em><\/p>\n\n\n\n

In our view, the current relative calm is an ideal time to assess core positioning, in terms of understanding embedded risks in major indexes and possible ways of addressing those risks. While we believe that the path of least resistance for equity markets is higher over the next few months, air pockets that introduce new risks, reversals, and volatility could emerge when the tariff pause ends in August.<\/em><\/p>\n\n\n\n

Russia and the conflict in Ukraine could be another wildcard after both the U.S. and Russia recently outlined revised positions to potentially end of the conflict. Should Russia-Ukraine ceasefire and China-U.S. trade negotiations drag on, the Shanghai Cooperation Organization meeting in Beijing this fall presents an opportunity for officials from China and Russia to regroup on political, economic, and defense matters.4<\/sup> For now, though, the U.S.-China negotiating framework puts pressure on Russia and Iran while reducing risks to the U.S. economy.<\/em><\/p>\n\n\n\n

Key Takeaways<\/h2>\n\n\n\n
    \n
  • Many index-based core equity strategies have changed meaningfully over time, resulting in greater exposure to foreign revenues, increased concentration in fewer stocks, and higher volatility.<\/li>\n\n\n\n
  • Investing in indexes like the S&P 500 does not ensure that revenue is derived in the U.S. But simple revenue and quality screens can reduce exposure to foreign revenues, potentially allowing investors to better target U.S. economic strength.<\/li>\n\n\n\n
  • Factor-based strategies focused on areas like momentum reversals or quality metrics like cash flow can help reduce portfolio volatility while not losing out on potential upside.<\/li>\n<\/ul>\n\n\n\n

    Taking Core Samples to Know What\u2019s There<\/h2>\n\n\n\n

    Many portfolios rely on an equity core that is based on an index or an index replication strategy. Major indexes can undergo significant changes over time, though, and a risk is that investors lose track of shifting exposures and characteristics given the perceived security and stability of indexes. Below, we highlight three such changes in the S&P 500 in the past 25 years and risks that they create.<\/p>\n\n\n\n

    First, the S&P 500 includes U.S. domiciled companies, however, the growth of international trade and new markets for goods and services mean that more companies now generate meaningful revenues abroad.5<\/sup> For investors looking for larger allocations to global markets, S&P 500 companies offer diversification, but that also translates to higher levels of idiosyncratic country risks that can hinder revenue generation and alter risks. For example, John Deere U.S. revenue accounted for 59% of sales and topline grew by 4.7% annually since 2010, whereas competitor Caterpillar made 53% of revenue from North America (including Canada and Mexico) and grew sales 2.8%.6<\/sup><\/p>\n\n\n\n

    \"s&p<\/figure>\n\n\n\n

    The growing concentration in fewer names across major indexes is another significant change, because that means more company-specific risk embedded in investment vehicles that are widely perceived as spreading risk around a broad-based basket of companies. The S&P 500 has grown increasingly concentrated in the top 10 names over the past 40 years, and today the concentration is reasonably acute. The top 10 S&P 500 companies account for 35%, the next 20 account for 16%, and the next 40 make up 15%. So, the largest 70 of 500 companies account for 66% of the exposure.7<\/sup><\/p>\n\n\n\n

    \"s&p<\/figure>\n\n\n\n

    Shifts in the volatility over time is a third consideration. Market gyrations ebb and flow across different economic regimes and fundamentals, however, the average volatility of the S&P 500 has generally moved higher decade by decade since the 1970s.8<\/sup> A broad-based equity index purportedly offering diversification that shields investors from volatility has increasingly delivered more market risk due to shifts in concentration, correlation, and possibly technical trading. As a result, we believe that investors with long-term holdings in major core indexes might want to assess how their risk profile has changed over time.<\/p>\n\n\n\n

    \"s&p<\/figure>\n\n\n\n

    Halting the Continental Drift<\/h2>\n\n\n\n

    The U.S. has been the best developed economy for years, and many domestic investors want significant exposure to their home market. In recent years, offshore flows to the U.S. have been relatively strong with investors drawn to the G7 economy that\u2019s significantly outpaced peers in GDP growth since the outbreak and recovery from COVID.9<\/sup> U.S. equity flows remained strong in the first quarter, but recent policy-induced volatility around trade escalation has triggered some reallocation of funds into international equities. This may be a longer-term trend but could also revert rapidly if U.S. fundamentals remain relatively strong.<\/p>\n\n\n\n

    \"compounded<\/figure>\n\n\n\n

    International exposures like ex-U.S. developed markets and emerging markets can play important roles in a portfolio, but many investors look to add them through dedicated allocations and potentially don\u2019t realize that large U.S. indexes already provide some of that revenue exposure. While international allocations can help achieve diversification, this can come at a cost\u2014international revenue within the S&P 500 has actually been a drag on the revenue growth of index constituents that draw significant sales from outside the U.S. From 2010 to 2024, U.S. sales of S&P 500 companies grew more than 1% faster than international sales flows annually.10<\/sup> Investors should be aware of this drag and potentially consider ways of achieving more pure play U.S. exposure that can be supplemented by dedicated exposure to other regions or countries.<\/p>\n\n\n\n

    \"s&p<\/figure>\n\n\n\n

    Companies deriving a greater portion of revenue from the U.S. have managed to keep 2025 sales estimates marginally higher than companies with greater international exposure, despite slowing confidence in the U.S. outlook.11<\/sup> Higher foreign exposure may be adding uncertainty to company plans. The U.S. isn\u2019t alone in modest earnings estimate revisions throughout the first-quarter earnings season, but the U.S. may offer a relative sense of stability should tariff concerns and economic uncertainty become more of a global phenomenon. Time will tell whether the U.S. exceptionalism of the last five years persists, but U.S. economic fundamentals have been a stabilizing factor so far.12<\/sup><\/p>\n\n\n\n

    Subduing Seismic Shifts with Factors<\/h2>\n\n\n\n

    Factor strategies use pre-set rules to select assets, often equities but not exclusively, that have common characteristics. For example, quality strategies target companies with strong cash flow generation and\/or good balance sheets. Momentum strategies typically follow market trends that are working. And contrarian strategies seek assets that seem to be underperforming, in anticipation of a rebound.13<\/sup><\/p>\n\n\n\n

    A wide array of factor strategies, featuring different flavors or rules, can alter portfolio return and risk profiles, making them valuable tools for investment beyond broad indexes.14<\/sup> One strategy that can help reduce volatility and counterweight index concentration is a contrarian dynamic factor rotation, which shifts allocation across different equity baskets based on relative performance. For example, an investor could leverage three strategies with different equity factor exposure and drop the best performing on a pre-set basis.<\/p>\n\n\n\n

    \"performance:<\/figure>\n\n\n\n

    This model strategy shifts between three different MSCI factor indexes that target high momentum, minimum volatility, and value. The performance of each index is calculated on a rolling two-year basis. Then, each quarter, the two worst-performing indexes are selected and equally weighted, while the best-performing index is dropped. The strategy delivers returns that are comparable to the broad S&P 500, but achieves these results with lower volatility, providing better risk-adjusted returns than just owning the broad index.15<\/sup><\/p>\n\n\n\n

    Another way that investors can use factors to change the quality of exposure is through fundamental factors, such as cash flow. Companies with strong and consistent cash flow usually have more predictable income streams and better balance sheets. They also often carry a lower cost of capital because they\u2019re lower risk, so a strategy tied to selecting a subset of companies with strong cash flow can be helpful in the core.<\/p>\n\n\n\n

    \"performance:<\/figure>\n\n\n\n

    The index modeled above selected the companies with the best free cash flow margins from the Russell 1000. The 100 companies were chosen on an annual basis and equal weighted in the portfolio. That group of stocks outperformed the S&P 500, driven in part by lower exposures to momentum and higher exposures to yield and liquidity. The index also had a Sortino ratio above 1.0, implying there was better upside opportunity given the downside risk.16<\/sup> In short, the modeled strategy delivered better returns and better risk-adjusted returns, potentially making it a good way for an investor to address some concentration and volatility risk associated with an index-based core allocation.<\/p>\n\n\n\n

    —<\/p>\n\n\n\n

    Originally Posted on May 28, 2025 <\/p>\n\n\n\n

    Footnotes<\/h2>\n\n\n\n
      \n
    1. Shalal, A. et al. (2025, May 12). Global stocks rally after US, China pause tariff war, but uncertainty remains, Reuters, https:\/\/www.reuters.com\/world\/china\/us-china-reach-deal-slash-tariffs-officials-say-2025-05-12\/.<\/li>\n\n\n\n
    2. Helfstein, S. (2025, April 23). Inflection Points: Roll with the Changes. Global X. https:\/\/www.globalxetfs.com\/articles\/inflection-points-roll-with-the-changes.<\/li>\n\n\n\n
    3. Helfstein. S (2025, March 14). Inflection Points: Trying to Reason with High Vol Season. Global X. https:\/\/www.globalxetfs.com\/inflection-points-trying-to-reason-with-high-vol-season\/.<\/li>\n\n\n\n
    4. Burrows, E. (2024, July 3). Leaders of Russia and China meet at a Central Asian summit in a show of deepening cooperation. AP News. https:\/\/apnews.com\/article\/russia-china-iran-shanghai-cooperation-organization-sco-7d0dcd21ad34b09cc149e30567198b06.<\/li>\n\n\n\n
    5. Global X analysis with information derived from: Bloomberg L.P. (n.d.) [Data set]. Retrieved on May 16, 2025.<\/li>\n\n\n\n
    6. Ibid.<\/li>\n\n\n\n
    7. Ibid.<\/li>\n\n\n\n
    8. Ibid.<\/li>\n\n\n\n
    9. IMF<\/li>\n\n\n\n
    10. Global X analysis with information derived from: Bloomberg L.P. (n.d.) [Data set]. Retrieved on May 16, 2025.<\/li>\n\n\n\n
    11. Ibid<\/li>\n\n\n\n
    12. Ibid.<\/li>\n\n\n\n
    13. Reiff, N. (2025, January 23). Unpacking the Smart Beta Strategy: What Investors Need to Know. Investopedia. https:\/\/www.investopedia.com\/terms\/s\/smart-beta.asp.<\/li>\n\n\n\n
    14. Ibid.<\/li>\n\n\n\n
    15. Global X analysis with information derived from: Bloomberg L.P. (n.d.) [Data set]. Retrieved on May 16, 2025.<\/li>\n\n\n\n
    16. Ibid.<\/li>\n<\/ol>\n","protected":false},"excerpt":{"rendered":"

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