Indexology^® Blog

The world seems to be awash with schisms these days.  There are always great divides in politics, but this year they seem greater than usual.  However, the schisms and splits in the financial world matter more for now: at the Fed, in differing growth rates among the US, Europe and China, and between stocks and oil.

The Fed appears to be divided between the hawks and doves when it comes to raising interest rates. Two speeches last week establish the contrasting positions. Fed Vice Chair Stanley Fischer suggested that inflation may be about to increase while affirming his belief that the Phillips Curve – the inverse relation between unemployment and inflation – is still is worth watching after six years of declining unemployment and flat to falling inflation.  The same day Fed Governor Lael Brainard noted that economic weakness abroad poses a risk to the US, suggesting the Fed might be better off not raising interest rates this year.  This schism should assure no change in the Fed funds target rate on Wednesday when the FOMC meeting issues its statement.

If there is such a thing as a three way schism, it is among growth in the world’s major economies. The US managed 1.9% real GDP growth in 2015, more than double the amount experienced in the Eurozone (0.4%), the UK (0.5%) or Japan (0.8%), but not even close to China’s 6.9% pace.  Even though China’s numbers are expected to slip slightly, this wide spread means that national economic policies may be working against one-another rather than together.  Expect conflicting arguments about managing currency exchange rates or losing jobs overseas.  The US dollar rose about 15% against major world currencies from mid-2014 to mid-2015; putting pressure on US exports while helping other nations’ export activity.

The relative behavior of stocks and the price of oil are another puzzle, although some recent analysis may hold an answer.  The chart shows the prices of the S&P 500 and WTI oil since the beginning of 2014. At first glance the two series move in opposite directions.  Since cheap oil is favorable for most US companies one would expect lower oil prices to be a positive factor for the stock market. However, this pattern reversed for a few weeks last summer and again since the start of 2016.  Two factors that would affect both oil prices and stocks the same way may be behind these reversals. Signs of increasing or decreasing global demand would cause both series to move together, overcoming the impact of lower oil costs. A second factor would be risk-on/risk-off which would push speculators out of both the oil and stock market.  A detailed econometric analysis of these factors is offered by Ben Bernanke.

By now we’re very familiar with the oft discussed “Low Vol Anomaly”. Diverging from conventional finance theory, which tells us that risk and return are directly related, low volatility stocks have outperformed over time and, as expected, with lower volatility. Ample research and evidence point to the existence of a low volatility factor comparable to other factors such as beta or small size or cheap valuation. Because this seems to fly in the face of what we think we know about risk and return, the low volatility factor is often referred to as the low volatility “anomaly.” The S&P 500 Low Volatility Index, for example, outperformed its parent S&P 500 (annual growth rate of 10.9% and 9.8%, respectively) despite exhibiting lower risk in the period between 1991 and 2015.

These returns are a snapshot spanning a 25-year period. Low Vol has, of course, underperformed at times during this period, most notably during the inflation of the technology bubble. The chart below maps the five-year performance spread on a rolling basis for a better picture of how Low Vol has behaved over time. Recently Low Vol’s performance spread has drifted around zero. Does this imply that the “low volatility anomaly” is spluttering?

We recently developed a simple methodology that can be used to assess the performance of factor (or other) indices compared to their cap-weighted parents. The methodology attributes a factor index’s excess returns both to its incremental (or decremental) level of risk and to a changed tradeoff between risk and return. We ascribe Low Vol’s “anomaly” to the tradeoff portion of the performance differential and the chart below tracks this element of return on a rolling 5-year basis. The recent performance challenges of Low Vol are attributable to its reduced level of risk in an environment that, until recently, has been favorable for risk-taking. Contrary to what the performance differentials suggested, the low volatility anomaly, as defined by improved tradeoff between risk and return, is alive and well.

This morning’s Financial Times highlighted a study of market volatility suggesting that return and volatility are inversely related — that “the correct response to an increase in volatility…is to exit the market.”

This is certainly true in the short run, as the table below confirms.

In months when the realized volatility of the S&P 500 was above average, the index’s total return was -0.03%.  When volatility was below average, the index’s average return was a much-improved 1.74%.   And regardless of whether realized volatility was above or below its midpoint, the S&P 500 tends to do much better when volatility is falling rather than rising.

But these are very short-term — indeed, monthly — effects.  What happens when we look beyond a one-month holding period?   Using the history of the Dow Jones Industrial Average (which extends back to 1896), we calculated returns for holding periods of various lengths, conditioned on whether volatility was above or below the 85th percentile of the distribution.  Given what we’ve already observed about the relationship between high volatility and low returns, it’s not surprising that investments made during periods of lower volatility outperform over short holding periods (up to about 11 months).  After that, however, fortune favors the bold:

Source: S&P Dow Jones Indices LLC, The Landscape of Risk, 2014. Data from July 1896 to September 2012. Charts and tables are provided for illustrative purposes. Past performance is no guarantee of future results.

The British financier Nathan Mayer Rothschild is reputed to have said “Buy when there’s blood in the streets, even if the blood is your own.” The saying may be apocryphal, but the insight it embodies is real enough.  One investor’s short-term risk can be the basis for another’s long-term gain.

In recent years, there has been much focus on the importance of climate change and how much greenhouse gas is produced in the process of conducting business.  While managing greenhouse gases is an important focus, is the future more about increasing efficiency across different depletable resources, such as water?

Because the demand across different scarce resources is correlated, it may be sensible to adopt a holistic approach when managing the efficiency of these resources rather than a disjointed, piecemeal approach.

In the research paper Resource Efficiency: A Case Study in Carbon and Water Use, we investigated whether or not there was an impact on the financial performance of carbon-efficient companies (i.e., companies that generate the least amount of greenhouse gases per U.S. dollar of revenue) and resource-efficient companies (i.e., companies that are efficient across their water use and greenhouse gas emissions).

Despite the limited availability of data, our preliminary findings suggested that, on average, efficient companies (Quintile 1) outperformed inefficient ones (Quintile 5) over a rolling 12-month or rolling forward basis (see Exhibit 1).

In addition to this, there are other reasons why carbon and resource efficiency are important.  If companies do not promote efficiency in their business activities, some of the risks they may face could adversely affect their future profitability.  For example, there are risks associated with increased regulation, resource depletion, reputation, and financing.

For more details on the results of our research, please click here to access the research paper.

The March rebalancing of the S&P U.S. Distressed High Yield Corporate Bond Index saw another increase in the number of qualifying constituents.  This marks the eighth increase of this kind in the last nine months.  The index, which is designed to measure securities with an option-adjusted spread greater than or equal to 1,000 bps, is down 35% over the past one-year period as of March 1, 2016.

While the monthly change in constituents saw a net increase of 53 issues, there were actually 137 new issues that entered the index universe.  Seventy issues were removed from the index as a result of improved credit spreads; however, 14 issues were removed from the index due to default.

Of the 14 issues in default, 10 were in the energy sector (five issuers), while four represented the materials sector (four issuers).  Combined with January’s activity, 14 issuers have been removed from the index due to default this year.  In comparison, there were 64 issuers that defaulted in all of 2015.

New issues added to the index had a total par amount of over 80 billion (approximately 15% of the index value).  The total par value of the index has increased 300% since July 2015.

Not surprisingly, the energy sector is the leader for both number of issues added and percentage of par amount added to the index.  There were a total of 72 issuers that were added to the index with representation from all 10 sectors.