Indexology^® Blog

When people think of a low-carbon economy, the U.S. may not be the first one to come to mind.  In almost all things ESG, Europe is considered the leader.  However, the U.S. market has made some strides in recent years.  The carbon footprint of the S&P 500^® has actually been declining since 2011, as illustrated in Exhibit 1.

This is good news for ESG market participants, although this decline has also started to stagnate, signaling that the low-carbon economy in the U.S. is at a critical point, with two possible outcomes.

On one hand, the head of the Environmental Protection Agency (EPA) recently questioned the role of carbon dioxide as a harmful pollutant—portending the potential future policy changes by the EPA.[1]  To put this in to context, back in 2007, the Supreme Court ruled that carbon dioxide was an air pollutant and that under the Clean Air Act, the EPA was all but required to regulate carbon dioxide, unless they were able to provide scientific evidence that greenhouse gases (GHGs) were not harmful.[2]  The recent statement questioning the link between carbon and climate change makes it look like the EPA may be leaning toward the latter part, and therefore attempting to deregulate the carbon economies—a concern for those focused on socially responsible investing.

On the other hand, while the change in EPA policy may be disheartening, it’s clear that the global markets feel differently.  This new stance signals a widely different viewpoint than most other countries around the globe.  In November 2016, delegates from 197 countries met in Marrakesh for COP 22, an annual climate change conference designed to reduce the production of GHGs.  This was a follow up to COP 21 in 2015, where these same countries (including the U.S.) met and signed the Paris Agreement, with the goal of preventing global temperatures from rising more than 2˚C above pre-industrial times.

In addition, market participant interest is increasingly focused on low carbon, particularly as those indices outperform the benchmark.  As illustrated by Exhibit 2, the S&P 500 Carbon Efficient Index and the S&P 500 Carbon Efficient Select Index have continued to outperform the benchmark (ever so slightly).

While public policy may no longer be implementing environmental regulation, market participant interest may be the driving force behind carbon reductions in the U.S.  We can expect that the world will continue to try to offset the damage done by GHGs—regardless of policy in the U.S.—and these efforts are likely to continue to affect financial markets, where interest in ESG investing continues to grow.

[1] http://www.reuters.com/article/us-usa-epa-pruitt-idUSKBN16G1XX

[2] http://www.nytimes.com/2007/04/03/washington/03scotus.html

The S&P BSE SENSEX is India’s bellwether index and is a globally recognized benchmark.  With the recent launch of the S&P BSE SENSEX 50 and S&P BSE SENSEX Next 50, Asia Index Pvt. Ltd. has expanded its S&P BSE SENSEX Index Series.  The newly launched indices are designed to measure the top 50 companies and the next set of 50 companies after the top 50 in the Indian market, respectively. Like other S&P BSE Indices, both adopt rules-based, transparent, and objective index methodologies.

Constituents are selected from the top 100 companies based on float-adjusted market cap and stringent liquidity filters.  The top 50 companies form the S&P BSE SENSEX 50, while remaining 50 companies from the pool form the S&P BSE SENSEX Next 50.

All three indices are diversified by BSE sectors, which reflect the respective weights of the sectors in the Indian market.  The key differences between these indices are number of companies covered and sector/size coverage. Finance and Information Technology are two largest BSE Sectors in S&P BSE SENSEX and S&P BSE SENSEX 50 indices; however Basic Materials and Finance are the two largest sectors in S&P BSE SENSEX Next 50 index. S&P BSE SESENSEX and S&P BSE SENSEX 50 covers nearly 52% and 65% of free float market capitalization of S&P BSE AllCap index respectively.

All three indices are designed to be investable, and their methodologies require stringent liquidity filters. The indices are weighted by float-adjusted market cap, similar to the methodology used by other index providers globally.  In order to keep index composition current and relevant to the market, the indices undergo rebalancing semiannually, in June and December.

Let’s look at the performance of each of them.

Exhibit 1: Performance of S&P BSE SENSEX Indices

Source: Asia Index Private Limited and S&P Dow Jones Indices LLC.  Data as of March 6, 2017.  Past performance is no guarantee of future results.  Chart is provided for illustrative purposes and reflects hypothetical historical performance.  The S&P BSE SENSEX 50 was launched on Dec. 6, 2016.  The S&P BSE SENSEX Next 50 was launched on Feb. 27, 2017.

Source: Asia Index Private Limited and S&P Dow Jones Indices LLC.  Data as of March 6, 2017.  Past performance is no guarantee of future results.  Table is provided for illustrative purposes and reflects hypothetical historical performance.  The S&P BSE SENSEX 50 was launched on Dec. 6, 2016.  The S&P BSE SENSEX Next 50 was launched on Feb. 27, 2017.

Since nearly 80% of S&P BSE SENSEX 50’s index weight overlaps with constituents of the S&P BSE SENSEX, the risk/return characteristics of the indices are similar.  The S&P BSE SENSEX Next 50 has a unique set of 50 companies, with nearly 55% of the index weight coming from mid-cap stocks, and it has shown consistently higher total returns than the other indices, with marginally higher volatility.

Source: Asia Index Private Limited.  Total returns and volatility as of March 6, 2017.  Past performance is no guarantee of future results.  Table is provided for illustrative purposes and reflects hypothetical historical performance.  The S&P BSE SENSEX 50 was launched on Dec. 6, 2016.  The S&P BSE SENSEX Next 50 was launched on Feb. 27, 2017.

Although OPEC agreed to cut production to help support the oil price, they may have miscalculated their power as a cartel.  The U.S. producers are filling in the gap causing inventories to soar, and that has caused the S&P GSCI Crude Oil index to fall 9.4% this month. It is the biggest 9-day decline since the period ending Nov. 7, 2016, when OPEC raced to produce ahead of the planned supply cut implementation.

Generally there is a low correlation of 0.28 between non-energy and energy commodities, using daily data back to Jan. 2, 1987.  Recently, the correlation has been rising, and while not excessively high, the pace at which it is increasing is noticeable.  On Jan. 13, 2017, precisely two months ago, the 30-day correlation between the S&P GSCI Energy and S&P GSCI Non Energy was -0.11, increased to 0.05 by Mar. 1, and is now 0.35, going from uncorrelated to moderately correlated in a short time.

Now there are 17 commodities besides crude oil that are negative month-to-date through March 13, 2017, that is the most down in a month with oil since Nov. 2015, when there were 21 down.  It is far worse than when oil was down in Jan. 2017 with only 9 other commodities.

Finally, the commodities that usually hold up with oil declines are now crumbling.  Normally several of the agriculture and livestock (coffee, soybeans, wheat, live cattle, lean hogs and corn) do well on average when oil drops.  Historically, corn holds up best, gaining 56 basis points on average in months oil falls.  Further, none of the non-energy commodities typically lose more than 1% in an average month that oil loses, but now the losses are substantial with greater than 1% drops month-to-date in 12 of 13 non-energy commodities that are down with oil.

Silver, live cattle and nickel are worst performing so far through March, 13, down 8.1%, 8.3% and 7.4%, respectively. Additionally, every sector is negative for the first time since Nov. 2015, including the industrial metals that were so promising have now fallen near 3% month-to-date in Mar. with only lead marginally positive, putting into question the optimism of growth that industrial metals (copper) are known for predicting,

We recently hosted Tim Edwards, Senior Director, Index Investment Strategy at S&P Dow Jones Indices, for an in-depth discussion about factor-based investing and the role it can play in a diversified portfolio.

Chris: What is factor investing? What are the factors?

Tim: To be a factor, two things in particular need to be true. The first is that it needs to be a characteristic of stocks that explains the differences between returns.  For example, a company’s size can often help explain their performance.  Size is a factor.  The second characteristic of a factor is that it is something that can be measured and captured.  For example, whether a stock is going to outperform would be very useful to know, but we don’t know which ones will do that.  So, that is not a factor.  The term “factor investing” really means investing in portfolios specifically designed to capture certain factors.

Chris: Factor investing is rooted in decades of research. Can you talk about some of the better-known factors, those that have shown persistence as consistent drivers of returns?

Tim: In markets across the world, lower-risk stocks have historically shown an improved risk/return profile, which has led to a wealth of research on the “low volatility” factor.  Perhaps even more famously, the value factor has accumulated close to a century’s worth of research and study.  Two more factors that are very commonly looked at include size – small companies tend to outperform large companies – and momentum, which is the concept of identifiable trends within individual equities, relative to each other and to the market.

Chris: Why have certain factors provided better risk-adjusted returns historically and how is this likely to persist in the future?

Tim: The outperformance of a few factors, I would identify low volatility, value and momentum in particular, has been the source of much academic and practitioner debate.   The long-term outperformance from these factors is, of course, a challenge to the efficient market theories preferred by academics.  For investors, the more pertinent question is whether they have the right exposures to these factors, and if the historical pattern of outperformance will continue.

Chris: What has the evolution of indexing meant for investors trying to seek factor returns or capture factor returns?

Tim: A good few decades ago, offering market-like returns was a highly rewarded activity. In time, managers’ performance began to be increasingly compared to broader market benchmarks. Then those same benchmarks became investible, at a relatively low cost, via the first index funds. Other strategies in the purview of active management eventually followed: value, risk management or momentum strategies became widely available in indices. As time passed, it became increasingly apparent that the core patterns of returns that many funds were offering were systematically replicable through a market exposure and a few select factor tilts. I see it as something of a democratization process, in which these forms of investing are examined, systematized, indexed and eventually made available to investors through index-linked investment products, typically at a much lower cost and with greater transparency.

Chris: In your mind is factor investing a free lunch? Is there a way for investors to know when to rotate between factors to end up with a better result than the market?

Tim: I would caution against a belief that any one of these, or any one combination of these, will deliver persistent constant outperformance. There’s no magic recipe that gives you the perfect solution over every time period, each of these factors will ultimately be affected by the macro environment.  Having said that, there is obviously the opportunity for investors to either diversify or better calibrate their exposure to factors either with the goal of a long-term outperformance, or better navigating the current environment.

Click here to access the full interview.

New exchange-traded funds (ETFs) are being created, and while that means we can expect innovation throughout the fund and indexing industries, “a proliferation of new funds could mean heightened risks for investors, particularly regarding ETFs, because many of those funds don’t trade frequently, making them more volatile.”[1]  ETFs are arguably responsible for a rapidly democratizing investment landscape.  Today, almost any firm can launch an index to be tracked by an ETF; one does not need to be an asset manager with billions under management.  Furthermore, market participants of any size can access strategies through an ETF that previously had been only available through hedge funds and investment banks.  However, with the increasing number of ETFs, it is imperative to better understand these funds and make informed decisions.

Is it an ETF?  If it Is, What Does That Mean?

The term ETF must always be qualified and investigated if the sought structure is a passive, index-tracking product that holds stocks—otherwise you may end up with something very different.

There are exchange-traded notes (ETNs), exchange-traded mutual funds (ETMFs), active ETFs (ETFs that don’t track an index), and within ETFs certain funds can be structured differently and not hold a single stock.  For example, grantor trusts can hold an interest in a physical commodity such as gold, while limited partnerships are more likely to be used for commodity-centric ETFs with exposure to futures contracts.  These structures are ETFs, but they can behave differently than open-ended funds and unit investment trusts, which many often mistakenly think follow the general structure of an ETF.  Open-ended funds and unit investment trusts are where one will most likely find a passive, index-tracking ETF that holds stocks.

ETMFs and active ETFs both should automatically be discounted if one is seeking a passive, index-tracking ETF.  ETNs can be passive and index tracking; however, their structure can introduce credit risk since they don’t hold any securities.  Rather, they are unsecured, unsubordinated debt securities issued by an underwriting bank.  Notably, a bank may close down even profitable ETNs “to clean up the liabilities on their balance sheets,”[2] whereas the closure of a profitable ETF is less likely.

Even ETFs Can Die

ETFs can close down.  In fact, “while ETFs have enjoyed explosive growth over the past decade, a record number of them—127—closed up shop last year, and liquidations are showing no sign of slowing.”[3]  So choosing an ETF structure does not guarantee anything, including the survival of the ETF, even if the performance is stellar.  In short, unless the ETF is profitable, the fund sponsor probably won’t keep it around for long.  That is why looking at the size of an ETF’s assets under management is important.

It’s All About the Index

So now we know enough to not consider certain vehicles just because they are exchange traded (whether they be funds or other types of products).  Even if they are true, passive ETFs that track an index or profitable ETNs, they are not immune to being shut down.  However, the most important factor to look at is the index.  The index will tell you what the ETF is attempting to achieve—it’s the code by which the fund runs.  With the growing number of ETFs and firms launching their own indices, it’s become critical to know who the index sponsor and calculation agent are.  Specifically, is the index administered by a reputable firm that complies with IOSCO principles?  Does the ETF track an index that was created by the fund sponsor (i.e., self-indexing) or an affiliate of the fund sponsor?  If so, is that self-created index independently calculated?  Assuming it is independently calculated, who exactly is calculating the index?

While there are no guarantees in financial markets, you can obtain some exchange-traded assurance when you want a truly passive ETF by understanding the structure of the fund, knowing that some may shut down, and the fund’s underlying index.  In an earlier blog,[4] I discussed a formulaic approach to ETF identification to help anyone in their quest for exchange-traded information.  Don’t be shy about using it.

[1]   Dave Michaels, https://www.wsj.com/articles/here-come-etf-regulations-and-why-the-industry-is-happy-about-it-1488770041

[2]   Sumit Roy http://www.etf.com/sections/features-and-news/why-credit-suisse-closing-its-popular-oil-etns

[3]   Simon Constable  https://www.wsj.com/articles/what-to-do-when-your-etf-shuts-down-1488769861

[4]   https://www.indexologyblog.com/2014/03/04/a-formulaic-approach-to-etf-identification/