Indexology^® Blog

Credit Suisse recently published their Global Investment Year Book for 2015 covering investment performance from 1900 to 2014 for 23 countries.  The results so far in the 21^st century are surprising: in 19 of the 23 markets bonds and fixed income outperformed stocks from 2000 to 2014.  The four equity markets that beat fixed income were Denmark, New Zealand, Norway and South Africa. In the 20^th century stocks beat bonds in every market. (Data on China do not cover the entire century so it 22 of 22 for 20^th century stocks.)

The results aren’t driven by bear markets in stocks. Although five markets show negative returns so far in this epoch, there were some reasonably strong equity markets which still lagged fixed income including Australia, Canada and Sweden. The explanation is both the currently low interest rates and the misfortunes of equities.  Ten year treasury yields peaked in the fall of 1981 and been bumping downward ever since.  The bull market in bonds covers the last fifth of the 20^th century and all of the 21^st we have seen so far.   The equity story is very different – once bond yields began sliding in 1981, equities began a 20 year bull market that carried them through to the turn of the century. Then fortunes turned and we have seen two deep bear markets where the S&P 500 lost about 50% since 2000.  With interest rates down to zero and even negative in a few European markets, one must believe that the bull market in bonds is close to ending.  Providing equities advance, the odds favor stocks out-performing bonds during much of the new century.

Active management is difficult; most of its practitioners underperform passive indices most of the time; and 2014 was a particularly tough year.  Not surprisingly, active managers are not touting last year’s performance.  Instead, the pitch for active management increasingly cites its putative social benefits — arguing, e.g. that “Markets are efficient only because active managers buy underpriced assets and sell overpriced ones.”  Too much indexing, the argument goes, will produce inefficient capital markets and insufficient price discovery, as “not enough” investors trade in response to perceived misvaluation, and “too many” investors simply accept whatever price the market gives them.

At the limit, this is a logical argument; one academic observer compares misvaluation to street crime and active managers to police officers on the beat.  More police, less crime; more active managers, less misvaluation.  But:

• A completely passive investor buys the market portfolio and then, for all practical purposes, never trades again.  In a world with some active investors and some completely passive investors, 100% of the trading is done by active investors motivated by perceived misvaluations.  With lower trading volume, there may be wider fluctuations around fair value than there are now, but there’s no reason to suppose that fair value won’t continue to be the central tendency of prices.
• If the fluctuations away from fair value become “too wide,” the process is self-correcting.  Wider departures from fair value mean bigger opportunities for the surviving active managers; bigger opportunities mean higher alpha for the successful; higher alpha means that assets flow back to active management.  Just remember that, weighted by assets, no more than 50% of the active managers can be successful — otherwise said, that while bigger opportunities mean higher alpha for the winners, they also imply lower alpha for the losers.
• Passive assets can rise dramatically without significantly diminishing the share of trading done by active investors.

The reason that passive assets can rise so dramatically is that active turnover is much higher than passive turnover.  In the chart above, we assume that the average active fund turns over 100% annually versus only 10% for the average passive fund (a very generous estimate on the passive side).  On those assumptions, if half of the market’s assets are indexed, active managers will still do 91% of the trading.  Indeed, if 90% of the assets are indexed, active managers will do 53% of the trading.

It is trading, not asset ownership per se, that sets prices and putatively corrects misvaluations.  If active trading makes for an efficient market, indexing has a long way to go before market efficiency is impaired.

The Brent crude oil and unleaded gasoline price difference, or “crack spread“, is a widely followed relationship to measure the value extracted along the chain of producing oil to refining it that can serve as a proxy for profit margins.  The EIA (Energy Information Agency) reported global gasoline supply and demand patterns have been evolving with demand greater than supply in Asia, Latin America, and the Middle East. In the U.S., the production of gasoline has been outpacing the demand, resulting in increasing exports of U.S. gasoline into the global market. Despite the relative cheapness of U.S. gasoline to the international markets from the fundamentals, the transportability has allowed benchmarks to measure the global seasonality.

In indexing, the difference in roll yields can be measured to theoretically reflect the relationship between excess and shortage in the oil and gas markets since it is the storage markets that drive the shape of the curves.  There is a historically wide roll spread between unleaded gasoline and brent crude oil, seasonally in each February, where the excess inventory of unleaded gasoline markedly exceeds the excess inventory of brent. What is interesting so far this February is that the spread is the narrowest in six years.

According to the IEA (International Energy Agency), global refining capacity is expected to rise after falling to a six-year low and that global refinery margins will come under renewed pressure. They predict further consolidation in the refining industry, especially in Europe and developed Asia as product markets continue to expand and globalise.

While the excess inventory of brent crude oil is larger at this time than in last February, when brent showed a shortage with a positive roll yield, the excess inventory of unleaded gasoline shown by the roll yield of -3.3% is down half from last year and is seasonally very low. This is illustrated in the graph below:

The last time the roll spread was this narrow in February 2009, it marked the bottom of brent. The fundamentals are different this time, driven much more by supply than demand, but the resulting inventory is what might matter most.

The overall medical trend rates covering all services have continued to be modest in the S&P data through the 3^rd quarter of 2014—increasing up to 3.5% on a 12-month moving average basis as of September[1].

But in 2014 the Individual trends reported by S&P are now over 45% based on 3-month moving average trends as of September.  These can reflect the impact of adverse selection, higher demographics and higher minimum (essential) benefits required under the ACA.  To one degree or another, the industry tried to anticipate these effects in the initial rating for 2014.  It remains to be seen if we see a similar effect on Small Group in 2015.  We would not expect the impact to be as dramatic on Small Group as it was for Individual in 2014, however the results remain uncertain at this time.  The Small Group ACA coverage requirement and electronic enrollment had been deferred until 2015 and insureds in this category were only allowed to enroll electronically staring in late 2014 so no experience due to Small Group ACA enrollment is yet apparent, but there could be an increase in these measured trends, although probably not as dramatic as the Individual trends.

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[1] We track the LG/ASO trends as representative of underlying trends, since Individual and Small Group are impacted more significantly by the Affordable Care Act (ACA).  Keep in mind that actual trends experienced by plans are likely to be higher than as reported in S&P data.  Trends experienced by large employers on plans that have not changed in the previous year could be higher by as much as 2% or more on bronze level plans and higher by 1% or more on gold level plans due to the effects of deductible and copay leverage.  So risk takers need to take this into account.  In addition, the S&P Indices do not reflect the impact of benefit buy-downs by employers (i.e., higher deductibles, etc.), since the indices are based on full allowed charges.  As noted above, actual trends experienced by employers and insurers in the absence of benefit buy-downs can be expected to be higher than reported S&P trends due to plan design issues such as deductibles, copays, out-of-pocket maximums, etc.   Benefit buy-downs do not represent trend changes since they are benefit reductions in exchange for premium concessions, but they can have a dampening effect on utilization due to higher member copayments, and this can have a dampening effect on measured S&P trends compared to plans with no benefit changes, further pushing up experienced trends relative to those reported in the indices.

Worried that maybe you missed the possible bottom of commodities after the S&P GSCI Total Return lost 7.5% in January, posting its sixth worst January in history since 1970? It’s possible there is still time even after the S&P GSCI TR posted (on Feb. 3, 2015) not only the 35th best day, up 4.13%, in its history since Jan. 6, 1970 (11,370 days ago), but the index posted a 3-day gain of 10.03%.  This is only the 5th time in history the index has posted a 3-day gain over 10%.

August 3, 2009 ended the last 3-day period the index gained over 10%, up 10.64%. Also in 2009, January 5th ended the largest 3-day gain of 14.31%.  The chart below shows return following these spikes. Notice there was a 26.7% drop from Jan. 5 to Feb.18 of 2009 before a 41.7% gain through Aug. 3 of that year. The S&P GSCI TR continued to increase 30.8% until its peak on April 8, 2011.

The other two 3-day periods the index gained more than 10% ended on August 6th and 7th in 1990, posting returns of 13.65% and 10.83%, respectively. Notice after this period, the index peaked on Oct. 9, 1990 gaining an additional 25.2% after the historically big 3-day rise. Subsequently it fell 26.8% through Jan. 18, 1991 before rising 80.7% through Jan. 6, 1997.