Indexology^® Blog

Different sectors within the same country can perform differently.  Not all sectors of the economy perform well during a bull market and vice versa.  Hence, an investment fund heavily focused on one or two sectors could be more volatile and susceptible to a single market incident or regulatory measure.  In addition, no particular sector can shine in all economic climates and will have ups and downs during different periods.  To attempt to reduce volatility caused by this sector movement, an investment fund (tracking a single country in particular) could track an index with a more diversified sector allocation.

Chinese Equity Indices Concentrate on the Financial Sector
When we take a closer look at some key Chinese indices which track the Chinese equity market, we see that they tend to have a high allocation to the financial sector, some even more than 50%.  In fact, many Chinese financial companies are massive, and some of them are state-owned enterprises supported by the government.  They tend to have large market capitalization and are liquid, enabling them to pass the market-cap and liquidity screens required by the Chinese indices, therefore making them eligible for index inclusion.

However, the Chinese indices selecting the largest stocks tend to overweight the financial sector but underweight other growing sectors that do not have a high market cap.  In order to give an accurate representation of the broad Chinese equity market, an index should be more diversified across different sectors.

The S&P China 500 Enhances Sector Diversification
To approximate the sector composition of the broader Chinese equity market, the S&P China 500 has a unique constituent selection criteria.  This index compares and matches the sector breakdowns of selected stocks in the S&P Total China BMI, which consists of about 3,000 constituents and represents the entire investable universe of Chinese companies.  The S&P China 500 is less concentrated in the financial sector compared with other key China indices (such as the S&P China A 300 Index) and closely matches the sector weights of the broad Chinese equity market, as represented by the S&P Total China BMI (see Exhibit 1).

The world’s equity markets have encountered a rocky introduction to 2016; including the worst ever start for the Dow Jones Industrial Average (against a record that stretches back to 1897) and steep falls across developed and emerging markets.  Equity markets are down more or less everywhere, and in many cases materially so.

What difference does a week make?

Does the performance in the first seven days of the year matter to investors who intend to hold through to year-end?  One would suppose not especially: there are 51 weeks to go, we have covered less than 2% of the year and – in the abstract –the first week’s performance should have only a tiny (although certainly non-zero) influence on the whole year’s return.  Yet, history suggests the opposite.  Some weeks were more important than others, and the performance in first week of the year was particularly indicative of the year’s returns.

How important is the first week?

Taking the international blue-chip S&P Global 1200 and its performance over the past 25 years as our object of study (similar results may be obtained with the S&P 500), it is clear that there is a strong historical relationship between the performance during the first week of the year and the overall year’s return, with a positive correlation of 0.41.  Not all weeks are equally important

Some weeks seem to be more important than others, or even provide an entirely opposite relationship to that expected; the third week in May, for example, seems to be negatively related to performance throughout the remainder of the year. (Support, perhaps, for notion that one should “sell in May and go away”.)

Which is the most important week?

Perhaps thanks to the return of investors from their holidays and the frequent location of elections during the period, the first week of September appears to be the most influential week for returns.  This is followed by the second weeks of November and March, then the second week of September.  The first week of the year appears in fifth place – still pretty influential, but far from the most important.

Conclusions

Historically speaking, years that have started badly have more frequently ended badly – and to a greater extent than might be supposed, given the expected impact of a single week’s performance.  However, those who wish to divine the market’s yearly performance from that of a single week might be better off waiting until September.

Despite the weakness in local currencies, the S&P Pan Asia Bond Index, which is designed to track local currency bonds in 10 countries and is calculated in USD, delivered a total return of 1.45% for 2015.  The S&P Pan Asia Corporate Bond Index rose 2.54% in the same period, outperforming the S&P Pan Asia Government Bond Index.

Among the 10 countries tracked by the S&P Pan Asia Bond Index, India was the best-performing country for the year; the S&P BSE India Bond Index rose 8.40% in 2015, while its yield-to-maturity closed at 7.89%.  The S&P China Bond Index went up 8.05%, despite the equity market volatility and slowdown in China.  Though these returns were shy of their double-digit gains of 2014, the gains were robust given the challenging market conditions.  Indonesia had a volatile year, the S&P Indonesia Bond Index managed to reverse its earlier loss in Q3 2015 and ended the year with a 4.35% total return; its yield-to-maturity reached 8.88% and it was the highest-yielding country in the region.

The size of Asia’s local currency bond markets, as measured by the S&P Pan Asia Bond Index increased 21% to USD 8.40 trillion in 2015, which reflected the continuous market expansion.  The market value tracked by the S&P China Bond Index expanded 40% to RMB 36.9 trillion, fueled by the municipal bond replacement program and the growth in the corporate market.

Exhibit 1: Total Return of the S&P Pan Asia Bond Index Series in 2015

Source: S&P Dow Jones Indices LLC.  Data as of Dec. 31, 2015.  Chart is provided for illustrative purposes only.

Exhibit 2: Yield-to-Maturity of the S&P Pan Asia Bond Index Series

Source: S&P Dow Jones Indices LLC.  Data as of Dec. 31, 2015.  Chart is provided for illustrative purposes only.

The New Year opened with large declines and massive volatility in China’s stock market.  According to US press reports, continuing declines in the value of China’s currency, the RMB, are a major factor in the poor performance of the market. While the RMB has slid against the dollar, falling from 6.21/USD at the beginning of 2015 to 6.59/USD on January 7,  2016, a loss of 5.8%, it appreciated when measured against the Australian dollar, the euro and the British pound.  China’s currency may be weakening, but that is only part of the FX story – the rest is the strengthening of the US dollar.

The table shows how the RMB has moved against the dollar, yen, pound, euro and Australian dollar. Since the beginning of last year the RMB fell vs. the dollar and the yen, was roughly flat against the pound and rose against the euro and the Australian dollar.  Estimates of trade between China and other countries, reported by the People’s Bank of China in constructing a trade-weighted index of the RMB, show that US traded was 26.4% of the total, euro-denominated trade 21.4%, yen-denominated 14.7%, 6.6% in Hong Kong Dollars and the rest spread across eight other currencies. These figures confirm what the table above shows: the RMB is not universally weaker. Rather, its weakness shows up in about half its trade covering the US, Japan and Hong Kong.  With other currencies in other markets, the RMB is stable or appreciating.  While exchange rate shifts of 5% to 10% in a year are large, the RMB’s movement cannot explain most of the difficulties facing the Chinese stock market.

The chart shows the exchange rates measured as indices (RMB per foreign currency) where all indices are based at December 8, 2014 =100.  Since higher numbers mean a weaker RMB, the vertical axis is inverted. The Chinese devaluation of August 10-11, 2015 is clear on the chart.   The sharp declines in the red and blue lines at the lower right are the weakness against the US dollar and the yen.

Low volatility strategies were a popular and growing category in 2015, and if the first several days of 2016 are any indication, it wouldn’t be surprising to see their popularity continue in the new year. That said, the topic of low volatility investing often comes with much discourse. A frequent argument is that a low volatility tilt is very similar, if not synonymous, to a bet on a small number of sectors or industries. In its 25-year history, the S&P 500 Low Volatility Index has often had high concentration in low volatile sectors – most frequently Utilities, Financials, and Consumer Staples. The index seeks out the least volatile stocks—with no sector constraints—so having large positions in sectors with relatively lower risk is not surprising.

However, there’s more to the low volatility story than a sector bet . As an exercise, we produce a hypothetical low volatility portfolio whose sector weights match those of the S&P 500 Low Volatility Index but whose sector returns match those of the complete S&P 500. The hypothetical results tell us to what extent Low Vol’s results come from sector tilts alone, vs. stock selection within sectors.

As shown below, over the last 25 years the hypothetical portfolio’s standard deviation was between those of the S&P 500 and the S&P 500 Low Volatility Index. Being in the Low Vol’s sectors during this period accounted for more than two-thirds of the total volatility reduction achieved by the S&P 500 Low Volatility Index. In the same period, the return increment attributed to being in the “correct” sector was only 24%. More than three-quarters of Low Vol’s outperformance is idiosyncratic to its stock selection methodology.

We’re not alone in arguing for the existence of the low volatility effect independent of sector impacts. Baker, Bradley, and Taliaferro, in decomposing the low risk anomaly, found that stock selection contributed to higher alpha, while the contribution from industry selection was negligible. Asness, Frazzini and Pedersen concluded that even holding the industry effect neutral, low volatility bets exhibited positive returns.

The implication of all this research is that a sector tilt can’t account for all the performance differentials of low volatility. To assume that the two strategies are synonymous is to leave something on the table.