Indexology^® Blog

A heavy weight battle over economic policy and financial markets is brewing between the Bank for International Settlements (BIS) in one corner and the International Monetary Fund (IMF) in the other. Meanwhile the world’s major central banks may be lining up on one side or the other with the Bank of England (BOE) moving towards the BIS and the European Central Bank (ECB) drifting closer to the IMF. The Bank of Japan (BOJ), having embraced Abenomics, is ahead of the IMF.  The Federal Reserve appears to be seeking a neutral stance, but that could change with the next speech or testimony.

The BIS, the bank for central bankers, argues in its just released annual report that markets are a little too euphoric and giddy; that it’s close to the time when interest rates should be raised.  While the BOE may agree – it has already moved to slow down mortgage lending and rein in a housing boom before it gets out of hand – the BIS is clear that higher interest rates, not limits on mortgages are what’s needed.  Meanwhile, the IMF continues to worry that the expansion might stall and lead to deflation. The deep plunge in first quarter GDP in the US reinforced the IMF’s fears, causing them to cut their forecast of US growth for 2014. The ECB should be, and is, worried about deflation and may be preparing for even lower interest rates and its own version of quantitative easing down the road.

The BIS’s immediate target is to return some real risk to our ever-rising stock markets and remind investors that taking on more and more risk can lead to a bad end.  The BIS is removed from domestic politics in the countries whose central banks it serves; it is in a position to advocate policies like higher interest rates that could push stock prices down. Some of the other banks would find it harder to argue for raising interest rates and discouraging risk taking.

The Federal Reserve, like the other central banks, must be aware of the politics.  For the moment everyone is convinced that the Fed will raise interest rates in the middle of next year.  Until something changes this consensus, the Fed is likely to bide its time, continue trimming back on quantitative easing and watch both inflation and the financial markets.  Whether or not the 2015 consensus is correct, when rates go up, it will be a surprise and stocks will more than likely go down.  We may be safe for the moment.

The month of June came quickly to a close and with it the half year 2014 index results.  At the start of the year expectations were for yields to be above 3% and climbing.  In reality rates have done the opposite as the yield on the S&P/BGCantor Current 10 Year U.S. Treasury Index is a 2.52%, far from its December 31^st level of 3.03%.

The S&P Municipal Bond Index has returned 6.08% year to date and is off to its best mid-year return since June of 2009.  Yields have remained relatively stable at 3.96% on a tax equivalent basis after having started the year 5.06%. High yield municipal bonds tracked in the S&P Municipal Bond High Yield Index have continued to outperform their corporate junk bond counterparts by returning 8.54% year to date.

The S&P/BGCantor U.S. Treasury Bond Index has returned 2.03% year-to-date.  This  mid-year return erased all of 2013’s negative 1.87% with 0.16% to spare.  Short and intermediate maturity treasury returns have forced performance seeking investors to assume the risk of the longer end such as the current 13.53% return from the S&P/BGCantor 20+ Year U.S. Treasury Bond Index.  Another alternative to improving performance is the picking up of yield by moving down in credit rating.  Investment grade corporate bonds as measured by the S&P U.S. Issued Investment Grade Corporate Bond Index and the more speculative grade S&P U.S. Issued High Yield Corporate Bond Index have returned 5.59% and 5.55% respectively.  Lagging behind high yield for the first half of the year is the speculative grade loan index, the S&P/LSTA U.S. Leveraged Loan 100 Index, which has returned 2.48%.

Recently the discussion of inflation has come up after a third increase in CPI which presently stands at 0.4% month-over-month.  The Fed had stated that even though recent inflation measures are a bit high, the data is noisy.  A wait and see approach has been adopted by the Fed as mentioned in Eric Morath’s Wall Street Journal article, U.S. Inflation Hits Highest Level for Year and a Half.  Inflation protection securities as measured by the S&P U.S. TIPS Index have returned 5.63% year-to-date.

Between World Cup Football and the upcoming U.S. July 4^th holiday, not much productivity is expected for this week.  In addition to the football matches, the economic calendar could add some excitement for market participants.  Today has already seen the release of the Chicago Purchasing Managers Statistics (62.6 actual versus the prior 65.5), U.S. Pending Home Sales Index (6.1% actual vs. 0.4% prior) and the Dallas Fed Manufacturing Index (11.4 vs. 8.0 prior).  The next few days will provide ISM Manufacturing (55.9 expected), Construction Spending (0.5% exp.), MBA Mortgage Applications (prior: -1.0%) and Factory Orders (-0.3% exp.).  July 3^rd’s schedule contains Trade Balance but also the significant numbers of the Unemployment Rate and Initial Jobless Claims.  The U.S. markets will be closed for the 4^th of July holiday, ending the week.
Source: S&P Dow Jones Indices, Data as of 6/27/2014

Note: The S&P/LSTA U.S. Leveraged Loan 100 Index comparison uses yield-to-maturity.
Source: S&P Dow Jones Indices LLC and/or its affiliates. Data as of June 30, 2014. The chart is provided for illustrative purposes. Past performance is no guarantee of future results.

In late 2013 and early 2014, we heard considerable chatter about the coming “stock picker’s market.”  2014 would favor stock selection strategies, it was said, because intra-market correlation was falling as macro-economic risks receded.  This morning’s Wall Street Journal reports that the contrary view — that low levels of stock market dispersion would make 2014 an especially difficult year for active managers — has been vindicated.  “So far in 2014, more actively managed mutual funds are trailing market benchmarks than in any full year since 2011…”  Hedge fund performance is said to be equally disappointing.  

The critical variable in understanding why active performance has been disappointing is the continuing low level of equity market dispersion.  Computationally, dispersion is a (weighted) standard deviation of cross-sectional returns.  Conceptually, it helps us gauge by how much the “better” performing stocks beat the “worse” performing stocks.  Economically, dispersion tells us how much over- or under-performance we are likely to experience.  When dispersion is low, there is less opportunity either to succeed or to fail.

An easy way to see this is to consider the difference in returns between the equally-weighted S&P 500 and its “standard” capitalization-weighted counterpart.  The equally-weighted S&P 500 tells us the performance of the average stock in the index.  (The cap-weighted 500, in contrast, tells us the performance of the average invested dollar.)  In 2013, the equal-weight 500 outperformed the cap-weighted version by 3.8% (36.16% vs. 32.39%).  For the first half of 2014, the spread was only 1.5% (8.66% vs. 7.14%).

The spread between equal- and cap-weighted performance tells us how much incremental return an investor could achieve by choosing a random stock — figuratively, by throwing darts at the financial page.  At 1.5%, this payoff to blind luck is quite low by historical standards.  Since the average manager typically underperforms random selection, and since fixed investment costs do not vary with dispersion — it’s not surprising that the first half of 2014 has been a particularly difficult environment for active stock selection strategies.

Unless dispersion increases substantially in the next six months, the rest of the year is likely to be just as difficult.

As markets are becoming more advanced and mature, investment strategies are incorporating different styles and methods to achieve desired returns.  There are growth and value styles, fundamentally driven strategies, tactical allocation strategies, sector-based strategies and the list goes on.

We never know when a trend toward a certain style or strategy may take off and gain popularity among portfolio managers and investors.  If we were to explore the sector-based approach, we could easy identify some clear advantages.  First, it showcases a clear classification in which the focus toward that sector and its trends can easily be tracked with changing conditions, as companies within that sector will tend to behave similarly.  Sectors can also be used as a basis for various investment strategies, and they may help manage risk efficiently by titling sector preferences based on required risk exposures.

In my previous blog “Building the Hope for Change,” I mentioned the Indian Planning Commission’s 12^th Five Year plans that have outlined some major projects.  The new Indian government seems to have recognized the much-needed boost for infrastructure and is reviewing plans toward the same.

Last month, we launched the S&P BSE India Infrastructure Index amid a positive sentiment in the market. This index is focused on primarily five clusters: utilities, energy, transportation, telecommunications and the non-banking financial institutions that are categorized by the Reserve Bank of India as “Infrastructure Finance Companies” or derive major business revenue from Infrastructure Finance.  As spirits in the markets are soaring high, this index has reflected the mood with an annualized one-year return of 54.03% (one-year annualized total return as of June 16, 2014).  A comparison with the bellwether S&P BSE SENSEX at 33.39% (one-year annualized total return as of June 16, 2014) and the S&P BSE 500 at 35.77% (one-year annualized total return as of June 16, 2014) showcases the S&P BSE India Infrastructure Index’s outperformance in the one-year category.

Exhibit 1: Comparison of One-Year Annualized Total Returns

Source: Asia Index Private Limited. www.asiaindex.co.in  One-year annualized Total return for the year ending June 16,, 2014.  Charts and graphs are provided for illustrative purposes.  Past performance is no guarantee of future results.  This chart may reflect hypothetical historical performance.  Please see the Performance Disclosures for information regarding the inherent limitations associated with back-tested performance. 

If we evaluate the performance of the indices over a longer term, we see that the trend of out performance may not be similar, hence it is important to evaluate the investment profile and time horizon when investment strategies are formulated.

Index investing can easily facilitate sector investing.  With lower costs and ease of transaction, this form of investing helps support various investment strategies.

To learn more about Infrastructure Investing, listen to our our webinar from last week “Trains, planes & Infrastructure Investing.”

Some stock selection schemes seem silly.  This weekend’s Wall Street Journal reports the results of two hypothetical portfolios which are clearly intended to be nonsensical.  One example, the so-called “Graham and Buffett Portfolio” comprises stocks whose ticker symbols consist only of the letters found in the names “Benjamin Graham” and “Warren Buffett.”  Silly it may sound, but a 20-year backtest of the Graham-Buffett portfolio shows that it handily outperformed the S&P 500.

The Graham-Buffett portfolio is a more complicated variation on a theme sounded earlier by Vanguard Group.  The Vanguard “AlphaBet” portfolios depend only on the first letter of each stock’s ticker.  Like the Graham-Buffett portfolio, the backtested Vanguard AlphaBets also outperformed the S&P 500.  (This is especially impressive given that active large-cap U.S. managers typically underperform.)

The Journal argued that these results depend on data mining — that is, the ability of backtesters to keep trying various rules until they find “something, anything, that would produce groups of stocks with high returns.”  “Data mining” thus connotes a degree of intellectual dishonesty.  We agree that investors should regard any backtest results with a fair degree of skepticism, but the explanation for the Journal and Vanguard results may be much simpler — and reveal an important truth.

Building a portfolio, in either a backtest or real time, is a two-stage process:

• The first step is security selection— the process by which we determine which stocks should be part of the portfolio.  Selection mechanisms can be fundamental or technical or quantitative — or some combination.  They can also be nonsensical, as with the Journal and Vanguard examples.  Importantly, when we say that a stock selection mechanism is nonsensical, we’re also saying that you’d do just as well by selecting stocks at random.
• The second step is portfolio construction — the process of weighting and constraining that combines the stocks we’ve selected into a final portfolio.

The most important thing about the Journal and Vanguard portfolios is not their (somewhat similar) stock selection processes.  The most important thing is that after they determine what stocks they want to own, the portfolio construction process weights each stock equally.

Equally-weighted indices tell us the performance of the average stock in the selection universe.  What return should we expect if we pick stocks randomly (or with a selection rule that is no better than random)?  With enough trials and enough time, random selection will produce the return of the average stock in the index. That means that the best estimate of the return of a randomly-selected portfolio is the return of an equal-weight index.  Over time, and certainly during the interval covered by the Journal and Vanguard portfolios, equal-weight indices outperformed their cap-weighted counterparts.

The Journal/Vanguard results are not only, and arguably not most importantly, about the perils of relying on backtests.  The most important point they illustrate is that equal weighting creates a powerful tailwind for a strategy’s performance.  Astute portfolio construction can mask flaws in security selection.