Indexology^® Blog

Today, the Dow Jones Industrial Average closed above 23,000 for the first time – offered here are a few factoids associated with that milestone:

• A Record – there have been four (4) 1000 point thresholds crossed in 2017, the most of any year since the DJIA’s inception in 1896.
• Less Impact Per Milestone – of course, as the Average gains in value each 1000 points represents a smaller percentage movement. In this case, the move from 22,000 to 23,000 results in a 5.18% return.
• A Steady Advance – there have been 51 new highs achieved year to date, the most since 2013 when the DJIA struck a new high 52 times. Prior to that, the most new highs were marked in 1995 (69 new highs).

Style consistency analysis is an essential element of the SPIVA^® India Scorecard that helps evaluate the percentage of funds that retained the same investment style classification throughout the investment horizon.  Other than performance and survivorship, the style consistency of funds is an important metric for market participant that can influence their asset allocation decisions.  In the SPIVA India Mid-Year 2017 Scorecard, we observed low style consistency for the five-year period across most fund categories, except the Indian ELSS (see Exhibit 1).

As of June 2012, there were 161 Indian Equity Large-Cap funds available for investment.  Out of these 161 funds, 34 funds were either merged or liquidated over the five-year period ending June 2017, which led to a survivorship rate of 78.88%.  Of the remaining 127 funds, another 68 drifted in style during the five-year period, resulting in a low style consistency of 36.65%.

Similarly, a low style consistency was observed for the Indian Equity Mid-/Small-Cap and Indian Composite Bond categories, which were 49.25% and 41.00%, respectively, over the five-year period. Over the same horizon, only Indian ELSS funds were style consistent.

Source: S&P Dow Jones Indices LLC, Morningstar, and Association of Mutual Funds in India.  Data as of June 30, 2017.  Past performance is no guarantee of future results.  Table is provided for illustrative purposes.

Exhibits 2 and 3 investigate further into Indian Equity Large-Cap and Indian Equity Mid-/Small-Cap funds that survived the five-year investment horizon but were style inconsistent during this period.  In the Indian Equity Large-Cap category, 68 funds changed their Morningstar category definitions[1] during the five-year investment horizon. Of these funds, 43 were reclassified to India Fund Flexicap, whereas 15 others were reclassified as India Fund Sector – Infrastructure, as per Morningstar categories as of June 2017.[2] In the case of Indian Equity Mid-/Small-Cap, 24 of the 67 funds were style inconsistent; 22 of these funds were reclassified as India Fund Flexicap.

Consistency in fund style is important because a change in investment style alters the risk/return characteristics of the fund.  Funds with inconsistent style may reduce the effectiveness of asset allocation decisions.

Source: S&P Dow Jones Indices LLC and Morningstar.  Figures based on SPIVA India Mid-Year 2017 Scorecard.  Table is provided for illustrative purposes.

Source: S&P Dow Jones Indices LLC and Morningstar.  Figures based on SPIVA India Mid-Year 2017 Scorecard.  Table is provided for illustrative purposes.

[1]   http://advisor.morningstar.com/Enterprise/VTC/CategoryDefinitions_India_April_2016.pdf

[2]   Please refer the SPIVA India Mid-Year 2017 Scorecard for current and historical mapping of SPIVA and Morningstar categories.

U.S. corporations continue to take advantage of the accommodative conditions created by a protracted period of low interest rates and strong market participant demand.  As of Oct. 1, 2017, U.S. investment-grade corporate debt issuance surpassed USD 1 trillion—three weeks ahead of 2016’s pace.  Additionally, the amount of speculative-grade corporate debt issued through the first three quarters of 2017 is 17% higher than it was after the first three quarters of 2016.  Combined, U.S. corporate issuance is on pace for another record year, which would mark the sixth consecutive year of increased corporate debt issuance (see Exhibits 1 and 2).

Corporations have not only been issuing more debt each year, but they’ve also been extending the maturities in an effort to lock in low funding costs for several decades.  In January 2017, Microsoft Corp issued a total of USD 7.5 billion of 30-year bonds with an average coupon of 4.2%.  One month later, in February 2017, fellow ‘AAA’-rated Johnson & Johnson issued USD 2.5 billion of 30-year bonds with an average of coupon of 3.7%.  Nearly 20% of the USD 1 trillion investment-grade debt issued YTD has been in 30-year term deals.  The average maturity of corporate issuances has grown significantly over the past 15 years (see Exhibit 3).

As a result of the continued increases in annual issuance amounts combined with extensions in average maturities, the total amount of U.S. corporate debt outstanding has more than tripled over the past 10 years.  The par amount outstanding of investment-grade corporate debt, as measured by the S&P U.S. Investment Grade Corporate Bond Index, has increased over USD 4 trillion since September 2007, while the amount of speculative-grade outstanding, as measured by the S&P U.S. High Yield Corporate Bond Index, has increased by USD 800 billion.  Over 60% of this increase can be accounted for by the companies in the S&P 500, as tracked by the S&P 500 Bond Index (see Exhibit 4).

Given the record amount of corporate debt outstanding, U.S. corporations have increased the degree of financial leverage to well above pre-crisis levels.  Perhaps more concerning is how corporations have chosen to use the proceeds of this record debt.  Most companies have favored short-term shareholder wealth (in the form of dividends, share buybacks, and M&A activity) over longer-term capital expenditures.  As U.S. equity markets continue to set record highs (in what seem to be weekly events), market participants may want to look at corporate capital management and, more importantly, how changes in corporate capital structures can potentially drive equity valuations.

Last week, readers of the Financial Times were regaled by suggestions that capitalization-weighted index funds were “hugely biased,” “undiversified,” and “too trusting of the market’s judgment on a handful of very large stocks.”  Criticisms of cap weighting aren’t new, of course, and at least in the near term seem not to have been very effective at deterring flows into passive strategies.  Nonetheless it may be worth asking how cap weighting achieved its prominent role in the investment firmament.

It was not, we hasten to say, because a handful of index providers decided to foist a flawed concept on the unsuspecting masses.  Indices began when journalists and stock exchanges wanted to communicate how the stock market had performed.  This raised an obvious question: how to combine the returns of a number of individual issues to summarize “the market?”  Combining returns requires choosing how each individual stock’s return is to be weighted.

There are a number of ways to weight individual returns, some more computationally convenient than others.  A comprehensive capitalization-weighted index will tell us the performance of the average investor, weighted by the amount of capital invested.  That is the key informational attribute that makes capitalization-weighted indices economically useful.  Note that this has nothing to do with index funds.  The S&P 500 launched in 1957, and its earliest cap-weighted predecessor in 1923, long before anyone thought of using indices as the basis for investment products.

Serendipitously, however, capitalization weighting turns out to have three characteristics that make it particularly attractive for index fund managers:

• It is, in economists’ jargon, “macro-consistent.”  If they wanted, all investors in a market could each hold a cap-weighted index fund.  Doing so does not require an offsetting tilt from another investor.  (In contrast, e.g., if I want to tilt toward value, someone else has to tilt toward growth.)
• Cap-weighted portfolios are relatively easy to maintain.  Unless the underlying index changes, a properly-constructed cap-weighted index fund is not required to transact.  Other weighting schemes (e.g., equal weighting or factor weighting) inherently require more turnover.
• Sharpe’s famous “Arithmetic of Active Management” concludes that “after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.”  The average passively managed dollar, in this formulation, is capitalization weighted.  Sharpe’s analysis does not hold for any other weighting scheme.

None of these arguments imply that capitalization weighting is appropriate for all investors in all circumstances.  But its popularity is not arbitrary or inexplicable.  We live in a capitalization-weighted world, and cap-weighted index funds are a simple reflection of that reality.  The law of gravity does not require our consent for its efficacy.  Neither does capitalization weighting.

This Fall has been a difficult time for property & casualty companies.  The fires in Northern California have destroyed thousands of homes and the relentless string of hurricanes have damaged parts of Texas, Louisiana, Florida, Puerto Rico and the U.S. Virgin Islands.

If these companies need to sell fixed income assets to offset liabilities they could impact the U.S. municipal and corporate bond markets.  While both of these markets have seen high demand during 2017, a secondary market influx of bonds may be a catalyst that begins to push yields higher.

A quick look at data from the Federal Reserve shows the potential. With over $300billion of municipal bonds and over $400billion of corporate and foreign bonds held by these companies shows the pool of assets these companies could tap to offset liabilities is significant.

Munis: While it may appear the most vulnerable, the municipal bond market has had it’s supply / demand equilibrium out of kilter for some time due to low new issuance.  The open question would be can it handle a wave of potential selling?

Corporate bonds: Again, U.S. and foreign demand for USD corporate bonds remains strong. Untested all year, this asset class has not seen any real selling pressure to benchmark against.

Table 1) Select asset classes held by property & casualty companies:

Meanwhile, the S&P National AMT-Free Municipal Bond Index (Investment grade) has recorded a 4.89% total return this year and the S&P 500/MarketAxess Investment Grade Corporate Bond Index has returned 5.59% return year-to-date (October 13, 2017.)