Indexology^® Blog

This weekend’s Financial Times brought John Authers’ provocative article on the frequency of financial crises.  Along the way, John gives us some excellent advice: “We should all work on the assumption that we do not know what will happen next.”

John’s view of crisis prediction applies equally to the quotidian work of investment management.  Since we don’t know which styles or managers will be in favor next quarter or next year, how should investors manage their agnosticism?  If we can’t know the future, we can at least rely on historical patterns of behavior.  One such pattern, with a pedigree of more than eight decades, is the observation that most active managers underperform passive benchmarks.  There are good theoretical reasons why this should be true, stemming most convincingly from the zero-sum nature of professional investment management.  If I’m to be above average, someone else has to be below average, and the weighted sum of the winners’ outperformance is exactly equal to the weighted sum of the losers’ underperformance — before costs.  The incremental costs of active management place active investors, as a group, at a permanent disadvantage relative to their passive competitors.

The theoretical argument is borne out by a virtual catalog of empirical data, most recently including our mid-year SPIVA report for the U.S. market.  For the 12 months ended June 30, 2017, 57% of large-cap U.S. equity fund managers underperformed the S&P 500.  Current results are somewhat worse for mid- and small-cap managers, and significantly worse across all cap ranges when the time horizon extends to three or five years.

We don’t know what will happen next year; we don’t know which active managers will outperform and which will fail.  What we do know is that investors who put index funds at the core of their portfolios have outperformed most active managers most of the time.  Investors who act accordingly have the odds on their side.

On Sept. 7, 2017, RobecoSAM and S&P Dow Jones Indices (S&P DJI) announced the results of the annual rebalancing of the Dow Jones Sustainability Indices (DJSI).  This year, a record of 942 companies (up 9 %) from around the world that had participated in RobecoSAM’s annual Corporate Sustainability Assessment (CSA) eagerly waited to learn whether they had been included in one of the most prestigious indices.

Over time, these indices have evolved into something much more than just benchmarks for sustainability-minded market participants.  These indices now serve as the gold standard for sustainability practices.  Companies use the DJSI to measure their efforts in a wide range of non-financial indicators against those of their industry peers and competitors.  As can be seen from the hundreds of press releases issued by companies, inclusion in the indices is not only a matter of pride, but it also validates their efforts to help solve some of the world’s greatest challenges.

This year brought the introduction of new criteria into the CSA, which serves as the research backbone for the DJSI and a growing number of ESG-focused products jointly offered by RobecoSAM and SPDJI.  Criteria like policy influence and impact measurement are on the pulse of what market participants are looking for in terms of forward-looking sustainability indicators.  Policy influence, for example, has traditionally been ignored in most sustainability assessments, but it deserves careful attention in terms of the potential reputational risks for companies and investors.  This year, RobecoSAM added questions to the CSA related to policy influence to get a better read on whether companies are indeed spending money on influencing policy for positive change, or whether they are in fact putting their money toward discussions that counteract positive change and hinder addressing global challenges, as outlined by the UN Sustainable Development Goals (SDGs).

Through the new questions on impact measurement, RobecoSAM identifies companies that have progressed only past measuring the monetary costs of investments made into environmental technologies or measuring the amount of carbon reduced from their operations, and to gauge the real implications and outcomes of these investments on local communities or human health, for example.  Market participants are increasingly looking for a measurable impact to be attached to their investments, and they often start by selecting companies that have begun to think about their impact in a broader sense.  The SDGs have given companies, investors, and governments a solid framework to measure their impacts against.  RobecoSAM is interested in identifying companies that truly understand that their operations, products, and services can have detrimental and positive impacts on the planet, and that these come with unique risks that need to be managed and opportunities that can be seized.

We recognize that these new CSA criteria pose challenges to companies, and that often, when it comes to policy influence, for example, companies tend to be hesitant to report on spending beyond their legal obligations.  With regard to impact measurement, many of the accepted methodologies like the Natural Capital Protocol and Social Capital Protocol are still in their infancy.  So, while in many cases company responses to these new CSA criteria were incomplete, a lot of encouraging data was collected, highlighting that companies are moving in the right direction: improved transparency and more strategic action toward achieving the SDGs by 2030.

Important legal information: The details given on these pages do not constitute an offer. They are given for information purposes only. No liability is assumed for the correctness and accuracy of the details given. The securities identified and described may or may not be purchased, sold or recommended for advisory clients. It should not be assumed that an investment in these securities was or will be profitable. Copyright© 2017 RobecoSAM – all rights reserved.

The CBOE Volatility Index^® (VIX) measures the implied volatility of the S&P 500^® over a 30-day period.  It is widely followed by market participants across asset classes to gauge market sentiment.  Traditionally, fixed income market participants have incorporated it into macro analysis.

Can VIX-related products be used as hedging tools for some bond sectors that exhibit certain equity-like features?  For high yield and emerging market bonds, credit and liquidity risks are more defining than duration risk.  Dor and Guan (2017) demonstrated that equity futures can be used to hedge high yield portfolios.  We investigated a correlation analysis of high yield and emerging market bonds to VIX and VIX futures.

Based on the correlation analysis, we can make the following observations.

There is a strong correlation between high yield and emerging market bond returns (0.58 and 0.79).  This could be due to the fact that emerging market countries and corporations that issue U.S. dollar-denominated bonds are likely to be closely tied to the strength of the U.S. economy and U.S. companies.  The overlapping investor base for high yield and emerging market bonds may also compound the return correlation between these two sectors.

There is a strong correlation between high yield and emerging market bonds and the S&P 500.  In other words, returns from U.S. large-cap stocks can explain a large part of variance in high yield and emerging market bond returns.  In our observation period, 51% of (square of correlation) variance in high yield bond returns and 36% of variance in emerging market bond returns can be explained by the variations in the returns of U.S. equities.

There is a negative correlation between VIX and VIX futures and high yield and emerging market bonds.  This demonstrates that as high yield and emerging market bonds have more exposure to credit spreads than duration risk, they tend to exhibit more equity-like properties and a strong correlation with equity volatility.

It is noteworthy that VIX futures exhibits stronger negative correlation with credit bonds than VIX spot, and therefore argues for a stronger case of VIX futures as a hedging instrument for bonds.  In fact, when correlation analysis is conducted for up and down market periods separately, it can be seen that this stronger negative correlation of bonds to VIX futures than to VIX spot comes mostly from down markets (see Exhibit 2).

Industrial metals hit multi-year highs last month with the S&P GSCI Industrial Metals Index up off its bottom nearly 60%.  This was mainly due to strong Chinese demand growth and a falling US dollar.  While the dollar has continued its fall in September, there is some concern over slowing growth in China.  On average, returns of energy and metals are resistant to drops in Chinese GDP growth.

However, industrial metals is the sector falling most often concurrently with slowing growth, falling together in over 60% of the time, and is the only sector that falls more frequently with slowing growth than it rises with rising growth.  Last Thursday, China reported its slowest growth in investment in nearly 18 years and the industrial metals has lost 3.1% in the first half of the month.  Nickel lost 6.0%, copper lost 4.1% and zinc fell 3.6%.  Aluminum and lead lost a respective 1.5% and 1.3%.

The growth concerns seem to have overpowered the inflation growth that usually boosts commodities.  Energy is the most inflation sensitive sector since it is the most volatile component of CPI, though industrial metals don’t get helped enough to outpace the demand growth concerns.  For every 1% rise in Chinese CPI, industrial metals have only risen 2.6% on average.

When I was a teenager growing up in Basel, I witnessed first-hand one of the events that put sustainability thinking on the agendas of the corporate landscape. On November 1, 1986, I was woken up by loud sirens. A disastrous fire had broken out at a chemical plant warehouse. Over 1,000 tons of agrochemical product and quicksilver had caught fire. The fire department was quick to contain the fire, but the water it used to extinguish it flowed into the Rhine. Overnight, the contaminated water turned the river a bright red color and caused unprecedented fish mortality.

Events such as these brought awareness of business risks, predominantly environmental risks, to the fore. Sustainability thinking had landed on the agendas of corporate executives!

Initially, it assumed a narrow interpretation of risk-management pertaining to environmental aspects. In other words, it was purely focused on what needs to be done to prevent operating licenses being revoked. However, over time, corporations began to see and enjoy the broader set of business opportunities that integrating sustainability practices more deeply can unlock. It is no wonder that the number of companies that actively participate in our Corporate Sustainability Assessment (CSA), an annual ESG analysis of over 3,900 listed companies, in order to secure a spot in the coveted Dow Jones Sustainability Indices, has continued to increase over the years.

Gradually, and with somewhat of a time-lag, sustainability thinking spread from the corporate sector to the investor community (see Chart 1). Despite this, the way in which the financial sector has embraced sustainability follows a very similar pattern to that of the corporate world.

When investors began to address the challenge of sustainability, the predominant focus was on risk management. Sound familiar? Specifically, they were focused on avoiding controversial investments. Exclusions were the natural answer, but in time and in much the same way as it happened in the corporate sector, this preliminary sustainability thinking evolved. The opportunities that come along with a deeper integration of sustainability principles now also became obvious to investors: identifying more innovative business models, attractive investments, better performance, to name a few. And while exclusionary screening is still the most widely applied Sustainability Investing strategy, more sophisticated strategies are rapidly gaining traction (see Chart 2).

Source: 2016 Global Sustainable Investment Review

Today, some say that integration of ESG in finance has become mainstream. Certainly, leaps and bounds toward a more sustainable approach to business have been made, but we have not yet reached a point where sustainability principles have permeated all the norms, be it in finance or in other sectors. That is the beacon we must continue to strive towards and we must be patient, persistent and rigorous in our endeavor.

Important legal information: The details given on these pages do not constitute an offer. They are given for information purposes only. No liability is assumed for the correctness and accuracy of the details given. The securities identified and described may or may not be purchased, sold or recommended for advisory clients. It should not be assumed that an investment in these securities was or will be profitable. Copyright© 2017 RobecoSAM – all rights reserved.