Indexology^® Blog

As assets tracking factor indices grow, so does the attention paid to evaluating and promoting these so-called “smart beta” funds.  Even the nomenclature attracts attention.  Professor William Sharpe, famous among other things for introducing the concept of beta to academic finance, has said that the term “smart beta” makes him “definitionally sick,” and lesser lights than he have also voiced reservations about the terminology.  Recently one of the financial community’s best journalists opined that smart beta may be less smart than many of its practitioners allow.

How should an investor evaluate a “smart beta” strategy?  One fair way is to evaluate it against the claims its advocates make, which requires that those claims be made explicit.  A factor index provides exposure to stocks with certain common characteristics.  Are those characteristics desirable in themselves, or desirable only because they are a means to a different end?  What, in other words, is the telos of a smart beta index?  This question puts a certain burden on both manager and investor, as clarity, already a moral virtue, becomes a practical necessity.

For example: suppose an investor is sold a value-driven “smart beta” ETF.  Its managers say (truthfully) that it will hold only stocks with above-average yields and below-average PE ratios.  The investor buys the fund and, several years later, finds that his “smart” ETF has underperformed the dumb old cap-weighted index from which its constituents were drawn.  But the ETF’s stocks were cheap when they were bought and they remain cheap.  Ought the investor to be aggrieved?  And if so, with whom — with himself, or with his ETF manager?

Of course, in our simple example, the investor may not have been fully clear, not even with himself, about his underlying assumptions.  He may have told himself that he bought the ETF in question because he wanted to own undervalued stocks, and this may even be true, as far as it goes.  But it may not go far enough.  Perhaps the fuller truth is that he wanted to own undervalued stocks as a means of outperforming a cap-weighted benchmark.  And smart beta’s failure to outperform, in this case, is as irksome as would be the underperformance of an active manager (although perhaps less painful in view of smart beta’s presumably-lower fees).

The investor, in other words, needs to understand his own motivation.  Does he want factor exposure in itself, or because it is a means to a different end?  An investor who undertakes factor exposure as a means of outperforming should be aware that, just as no active manager outperforms all the time, neither does any factor index.  The investor should strive to understand the conditions that will make for a factor’s success.  Equally, he should strive to understand his own goals and motivations.

Prices of existing homes rose 5.3% in the year ended December 2015, more than twice the rate of inflation.   However, the pace of price increases varies across the country with the strongest gains in the west and the weakest in the northeast, as shown by the chart.  Sales of both new and existing homes also vary across the country with more strength in the west.

The next S&P/Case-Shiller Home Price report will be releases at 9 AM Tuesday morning. It will show whether the west’s dominance continues and whether prices will keep climbing despite questions about the availability of financing.

The Affordable Care Act (ACA), signed on March 23, 2010, by President Barack Obama, has often been described as legislation to 1) make healthcare and health insurance more affordable, and 2) make health insurance more broadly available to Americans.  Key parts of the ACA have been discussed relentlessly in the market, in particular the requirements that people with preexisting conditions can’t be charged more or denied treatment, and the requirement that all Americans must have healthcare or face a tax penalty.  While the new rules imposed on the healthcare industry have served to increase accessibility, what has the impact been with respect to affordability?  In this two-part series, we will look at the impact of this legislation, first from the perspective of accessibility and whether enrollment has actually increased since the ACA was introduced, and then at affordability, or costs, and how overall costs in the individual market have been increasing.  We will use the S&P Healthcare Claims Indices to evaluate the success of each provision further.

Accessibility: Do More Americans Have Healthcare Coverage Today Than When the ACA Was Introduced in 2010?

According to the S&P National Healthcare Individual Claims Index, there appears to be strong evidence that there has been an increase in private enrollment since the introduction of the ACA.  The majority of this increase occurred concurrent with the introduction of the Health Insurance Marketplace in January 2014.  Because the initial open enrollment in the Health Insurance Marketplace was plagued with administrative problems, growth in enrollment was delayed.  In fact, in early 2014, the government announced that open enrollment would be extended to March 31, 2014.  As can be seen in Exhibit 1, individuals started to take advantage of this new coverage, and between October 2013 and September 2015, total enrollment increased by over 25% on an adjusted basis,[1] as measured by the S&P Healthcare Claims Indices for the individual market.  Given that the S&P Healthcare Claims Indices represent approximately 40% of the total commercial healthcare market in the U.S., we believe that it is reasonable to conclude that the ACA has induced more individuals to buy individual health coverage.  Also notable in Exhibit 1 is an increase in the cost trend from 5% annual to over 30% in 2014 on a 12-month basis, indicating that these additional enrollees had a significant impact on costs.

In part 2 next week, we will look deeper into the impact on costs that the additional enrollment had.

[1]   The enrollment numbers have been adjusted to remove the drop in enrollment due to the removal of a plan from the S&P Healthcare Indices in October 2014.

Every six months, S&P Dow Jones Indices publishes the S&P Indices Versus Active (SPIVA^®) Europe Scorecard, which seeks to compare the performance of actively managed equity funds across different categories, and in the SPIVA Europe Year-End 2015 Scorecard, we expanded it to cover more individual countries and regions.  Among the new additions are Italy, the Netherlands, Poland, Spain, Switzerland, and the Nordic region, with specific data for Denmark and Sweden.  This is also the first year-end report in which 10-year data is published for Europe. .  To access the full report, please click here and for the video summarizing the major findings of the report, please click here.

Global equity markets, as measured by the S&P Global 1200, rose 10.4% over the past one-year period, as measured in euros, which could largely be attributed to the European Central Bank’s quantitative easing program.  However, this apparently positive performance masked the heightened volatility that the equity markets experienced over the course of the year, which was a consequence of anemic Chinese growth, as well as the collapse in energy and commodity prices.

Compared to the S&P Europe 350, while 68.1% of active managers outperformed the benchmark over the short run, they underperformed the benchmark over longer time horizons.  63.8% of active managers underperformed the benchmark by the end of the three-year period, 80.6% in the five-year period, and 86.3% over the 10-year period.   Exhibit 1 shows the new categories highlighted in blue.

As for the global, emerging market, and U.S. equity categories, actively managed funds—in both euro and pound sterling—underperformed substantially in the short term (one-year category) and in the long run (10-year category).  For instance, 61.2% of global equity funds underperformed their benchmark over a one-year period, and 89.08% of funds underperformed the benchmark over a 10-year period.

Today in the Wall Street Journal, there is an article, “Airlines Retreat on Fuel Hedging“, that highlights the losses airline companies suffered by hedging against oil and gas rises. However, the article also points out that not all airlines hedged, including American Airlines Group (NASDAQ: AAL), who enjoyed the benefit of cheaper fuel. Scott Kirby, president of AAL, was quoted, “hedging is just a rigged game that enriches Wall Street.”

Kudos to him and his shareholders for betting in the right direction. Not every commercial consumer (airline) made that choice, but the important point is that hedging against an oil price rise is a choice about managing risk. Hedging price risk to keep a company in business is not a Wall Street game, but it is possible Kirby was referring to Paul Cootner’s research from MIT in the 1960’s that explains commercial hedging as a highly specialized form of speculation.

In a letter to the FT, Hilary Till points out the futures markets exists to help companies specialize in risk taking by allowing them to use the basis risk, the difference between the spot and futures prices, to manage risk. This is helpful since the basis risk is more predictable than the commodity prices themselves. In the same article, Till points out Holbrook Working’s research from Stanford in the 1950’s showing that it is not necessarily precise daily correlation that matters for choosing a proxy hedge, but whether the proxy hedge provides a business with protection during a dramatic price move that could bankrupt a company.

However, not all companies are similarly vulnerable to bankruptcy from commodity price moves. The producers need protection against price drops more than commercial consumers need protection against price increases. So, the producers go short to protect against price drops and the consumers go long to protect against price increases, and the result is naturally more commercial shorts than longs.

This also true specifically in oil where there has been consistently more commercial short hedging than commercial long hedging.

The reason this is the case is supported by two economic theories: 1. Hicks’ theory of congenital weakness that argues it is easier for consumers to choose alternatives so they are less vulnerable to price increases than producers are to price drops, and 2. Keynes’ theory of “normal backwardation” that argues producers sell commodities in advance at a discount which causes downward price pressure, which converges to the spot at the time of delivery.

In the futures market, this gap needs to be filled between producers and commercial consumers that are hedging, opening the door for long commodity investors to earn a return called the insurance risk premium. This is illustrated by the bigger share of non-commercial longs than shorts.

This relationship is time tested and has remained stable as examined by Bhardwaj, Gorton and Rouwenhorst. They conclude although open interest has more than doubled for the average commodity since 2004, the composition of the open interest has remained remarkably stable.

Oil index investors that use long futures should be excited if all of the above holds true and airlines really are retreating on their hedging. The implication is that there may be a bigger risk premium to be earned as the net shorts grow (from the absence of airline long hedging.) The oil producers still hold more risk than commercial consumers and will likely pay investors to offset that risk. The timing may be perfect too with the signals that show oil may have bottomed. You can read about these two signals here and here.