Indexology^® Blog

Investment managers are always looking for ways to control risk in their portfolios, as good risk management is paramount for long term accumulation of wealth, particularly in uncertain market environments! Portfolio risk protection can be employed utilizing many different methods, each of which can be unique to a particular manager’s style and core competencies.

Structural and tactical risk management are key components to consider when constructing dynamic portfolios. Structural risk protection comes in the form of running portfolios that are diversified by and within asset class in addition to purchasing diversified baskets of securities rather than individual issues.   But good diversification is only one layer of protection and as investors have learned, it can have an inherent weakness in bear markets where correlation between asset classes can go to one at light speed. Therefore, our firm believes it is important to add a layer of tactical risk management to the structural composition of a portfolio.

One very effective tactical method to control risk is to have the freedom and flexibility to alter the broad asset allocation of the portfolios between stocks, bonds, cash, alternatives, etc.  Having the ability to dial up or down the amount of stocks or bonds in a portfolio can clearly make a material difference, and can be employed efficiently with today’s impressive selection of exchange traded funds (ETFs).

Another tactical tool that allows investors to risk manage without having to make allocation bets is to employ sector rotation. Given the explosion of high-quality ETFs in the marketplace, sector-rotation strategies can be implemented to alter US equity sectors, country exposure, fixed income sector and rate sensitivities, and commodity and currency exposures.   While sector rotation won’t take an investor out of the market, simply altering what is owned can be a material factor in returns during risky markets.

As an example, those investors that were simply willing to alter their US equity allocations and purchase defensive US sectors in their portfolios suffered less downside volatility materially than the broad market during the last two bear markets. During the last two market downturns, an investor that invested in an equal weighted composite of non-cyclical sectors (staples, healthcare, utilities, and telecom) lost an average of 13% less than S&P 500® index, and the best performing defensive sector averaged losses of roughly 20% less than the overall market.

If you are an advisor or small investor that is interested in learning more about how to use ETF portfolios to mitigate risk, join us at the S&P Dow Jones Indices event: “Navigating Market Uncertainty” on October 8^th in New York City.

Alibaba appears to have seized the 2014 prize for the biggest IPO price jump – from $68 to $93 on the first trade – as well as driving more speculation about its possible membership in the S&P 500 than anything since Facebook.  Unlike Facebook, Alibaba is a Chinese company and is not eligible for membership in the S&P 500.  (It is likely to find its way into various S&P and Dow Jones Chinese stock indices at some point.)  In response to the questions about the S&P 500, S&P Dow Jones did issue a press release on September 12^th to clarify while Alibaba is listed on the New York Stock Exchange, S&P Dow Jones considers Alibaba to be a Chinese company.

So how did the most talked about IPO of the year end up on the NYSE? Alibaba is incorporated in the Cayman Islands and trades on the NYSE as an ADR.  Behind this is an unusual corporate structure with a series of companies which result in the shareholders having very little say about the board of directors, the management or anything else about the company.  The vast majority of Alibaba’s business is in China so one might think that the logical place to list would have been Shanghai or Shenzhen – China’s two stock exchanges.  Listing in China would have meant the stock would be inaccessible for investors outside of China and might have limited the buying at the IPO.  Hong Kong would have been possible except that the Hong Kong Exchange has stricter rules about corporate governance than the NYSE; Hong Kong declined the listing. Alibaba is not the first tech company to take advantage of the less strict corporate governance at the NYSE or NASDAQ.  Both Google and Facebook have multiple classes of shares with a super-voting class that assures insiders keep control of the company.   While Google and Facebook offer more transparency than Alibaba, the management is firmly in control.

Transparency for investors did score a victory last week in another place. CALPERS, California’s public employees’ pension system, the largest pension system in the US, announced it would sell all its hedge fund positions over the next year. CALPERS noted that returns haven’t met expectations, that the fees are quite high and that there is no transparency — investors don’t know what is being done with their money- they can only hope for returns.  One wonders whether CALPERS, or other pension plan that eschew hedge funds, will consider buying Alibaba ADRs.

August housing starts, reported today, were disappointing at 956,000 units, a drop of 14.4% from July and 8% from August last year. Only twice this year have monthly reports of housing starts topped a million units at annual rates – from 1991 to the financial crisis in 2008, starts were never below one million.  To a large extent building houses hasn’t recovered from the financial crisis. If one uses the average number of houses started from 1995 through 2004 as a pre-boom-bust normal measure, housing starts in August were 59% of the normal level.

The details suggest there is much more to the story. Single family homes started in August were 50% of the normal rate while multi-family homes (apartments) were at 94% of the normal pace. The chart shows that there was a change in the shares of single family homes and apartments.  The single family share (in blue) dropped beginning in 2007, rebounded briefly in 2009 when the government provided tax benefits to first time home buyers and then fell from 2010 on.

What happened to keep people in apartments?  Renters who decided not to become home buyers are a part of the story.  The New York Fed (click here) provides an analysis of why people are renting rather switching to being home-owners.  First time home buyers account for 30% to 50% of home sales. The principal answers, in the chart from the New York Fed, are not enough money, too much debt or credit isn’t good enough.  The damage of the financial crisis is still with us.  Mortgage rates and home prices are barely mentioned.  Moreover, both renters and home owners expect moderate increases the home prices, enough to stay a bit ahead of inflation. About 60% believe owning a home is a good or very good investment; another 29% are neutral on investment value; with little difference between renters and home owners.  The idea that the financial crisis relief should have focused more people in debt may make sense.

Will Scotland vote to become independent? That’s a big question, especially for the future of commodity indices.  This is since one of the largest commodities in the indices is Brent crude oil – the oil produced in the North Sea off of Scotland’s coast.  If Scotland separates from the United Kingdom, there may be consequences for the oil that is the arguable benchmark of the world.  According the Intercontinental Exchange (ICE), since March 2012, ICE Brent has been the world’s largest crude oil futures contract with annual volume reaching a record 159 million contracts in 2013, doubling market share since 2008.

From this, commodity indices have increased their allocation to Brent. Over the past 5 years Brent has replaced WTI at a relatively high pace. Notice in 2009, Brent was less than half WTI and today the allocations are near equivalent, especially in the S&P GSCI. Also notice the big increase in Brent in 2014 in the DJCI.

Although the U.K. only produces about 4.2% of Non-OPEC OECD or 89 kb/d of the world oil supply as seen below, the great majority of offshore production is in Scottish waters.

If Scotland votes yes to independence, their local oil market may have a much bigger global impact. Despite it’s size, it is the oil used to set benchmark prices in London each day. Just 2.4 mb/d of the oil from the U.K. and Norway, set pricing for about 60 million barrels of oil or 60% of global supply that is priced based on Brent crude oil. It is the dominant benchmark rate against which daily oil trades are priced worldwide. The new uncertainty may place great pressure on the oil price which may be magnified by the weakened local currency since it is denominated in dollars.

Brent’s turmoil could reverse the trend of increasing weight in the indices, giving the opportunity for WTI to grow again, especially if the U.S. starts exporting oil. However, the change could be gradual since the indices use five year averages in liquidity and world production.

The S&P Pan Asia Bond Index tracks the performance of the local currency bonds in the 10 Pan Asian countries. The market value tracked by the S&P Pan Asia Bond Index has expanded three fold to USD 6.7 trillion since the index’s first value on Dec. 29, 2006. This rapid expansion warrant some attention as it is compared with the total size of the global debt securities, which is estimated to be over $90 trillion, according to the Bank of International Settlements.^

If we look at the market composition of the S&P Pan Asia Bond Index, which is market value- weighted, it is not surprising to see the S&P China Bond Index has a dominant share of 59% with its market value currently stood at CNY 24 trillion. The S&P South Korea Bond Index and the S&P India Bond Index came second and third, respectively. Please see Exhibit 1.

Exhibit 1: Country Breakdown of the S&P Pan Asia Bond Index 

In the Pan Asian bond market, while the size of government bonds has doubled to USD 4.8 trillion, the size of corporate bonds jumped 9 times to USD 1.9 trillion in the same period! In fact, the market share of the corporate bond market rose from merely 9% to 28% of the index, which represents a significant reversion from traditionally underdeveloped corporate market, see Exhibit 2.

Exhibit 2: Sector Breakdown of the S&P Pan Asia Bond Index 

This growth dynamic is supported by a stronger investor demand, both locally and externally. Many Pan Asian local currency bond markets are now made easier for foreign investors to access, particular through the use of exchange traded products. The regulatory framework also becomes more welcoming, for example, the expansion of Renminbi Qualified Foreign Institutional Investor (“RQFII”) quota in China. Underpinned by the robust economic growth, the Pan Asia bond market has historically been attracting steady inflows.

^Source: http://www.bis.org/statistics/secstats.htm. Data as of December, 2013.