Welcome to the inaugural edition of our ETF update series, in which we’ll explore the issues, trends and market developments involving “smart beta” ETFs and factor investing.

By and large, volatility has been low across asset classes and markets so far this year. Some ascribe the calm to subdued economic volatility and continued central-bank accommodation in the form of easy monetary policy.

Whatever the reason, volatility has recently reared its head as the northern hemisphere entered its summer months, with 6 of the top 10 worst days occurring in June, July and August. In fact, even as the U.S. large cap market reached new highs, 44% of its stocks are actually in correction territory as measured by their drawdown of 20% or more from previous highs.

What Does Recent Volatility Mean in a Historical Context?

Another way of looking at market performance is to compare an equal-weighted index with a market-cap index to see if the market is broadening or narrowing. In other words, through this comparison, we can attempt to determine whether investors are favoring only specific stock sectors (e.g., large caps) or stock groups (such as the so-called FAANG stocks comprising Facebook, Amazon, Apple, Netflix and Google)—or whether their favor is broadening to encompass a larger part of the market.

Having run the comparison, we saw that, in the summer of 2016, markets were narrowing as large-cap stocks outperformed their small-cap counterparts. After the U.S. election, investors rewarded a broader segment of the market that had not been in favor. However, this “reward” lasted for all of one month before markets began to narrow again—and they have continued to do so in 2017.

One Way to Spot Trends: The Momentum of Factors

We have also seen two factors—company quality (as measured by such criteria as profitability, earnings quality, efficiency and leverage) and low volatility (as exhibited in low stock-price standard deviation)—be rewarded at the expense of company value and size.

Additionally, we see that quality and low volatility have become highly correlated with the momentum of stock prices (i.e., companies that have recently performed well). In other words, we’re beginning to observe that high-momentum stocks are also of higher quality and lower volatility—and that low-momentum stocks are inexpensive and smaller in size.

As a result of these correlations, a factor-weighted strategy focused on momentum may assign an overweight position to stocks in the information technology (IT) and healthcare sectors on the basis of their high quality and low volatility, whereas it could be underweight financial stocks.

What This Means for ETF Investors

What are factor-based ETF investors do in this environment?

In our view, it all comes down to perspective. If one believes the market will proceed on its current course, one may wish to pursue strategies that emphasize quality, low volatility and momentum. But if one foresees the prospect of higher sensitivity to price multiples (meaning that the market would be less inclined to pay for current and expected earnings), or a catalyst that provokes investors to take on more cyclical economic risk, then value- and size-based strategies may see a resurgence.

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