Indexology^® Blog

The ten year Treasury note closed with a yield over 2.5% this week, sparking talk that interest rates may have bottomed. The first chart shows the yield on the 10 year treasury going all the way back to 1953.  As seen there, the bottom in July 2016 at 1.5%. Last March the yield was 2.5%, it then fell to 2% in September before rebounding.

The bigger picture is revealed in the chart. We have either recently passed or appear to be approaching a major bottom in the bond markets.  With a few dips during recessions, Treasury note yields climbed steadily from 1954 until 1981, turned and began what was once called The Great Intergalactic Bond Rally. Starting in September 1981yields fell for the next 35 years.  While picking the precise bottom is challenging, it is increasingly likely that the long term decline in bond yields is drawing to a close.

Among the factors arguing that we are at a turn in bond yields are the economy’s current strength and momentum and the Fed’s decision to shrink its balance sheet and move away from quantitative easing as they raise the Fed funds rate.  Real US GDP growth in the second and third quarters of 2017 topped 3%. Real business fixed investment grew at 6% in the first three quarters of 2017. The unemployment is down to 4.1%. The economy is growing faster than its long term potential growth, putting upward pressure on interest rates.

The monetary policy that brought interest rates close to zero and supported the recovery from the financial crisis is over. The Fed’s attention is now directed at establishing a safety margin with the Fed funds rate well above zero so that it can cut rates when the next recession arrives.

A short term result of the Fed’s continuing increase in the Fed funds rate is a flatter yield curve as seen in the chart of the spread between the 10-year and two-year treasury notes.  Some analysts argue that a flattening yield curve may be pointing to future economic softness and might persuade the Fed to stop raising the funds rate. However, the current increase in the yield on the ten year treasury is giving the Fed more room for raising the Fed funds rate going forward.

Two by-products of the economy’s strength also support the idea that we may be close to a bottom in bond yields. Inflation expectations (see next chart) are no longer falling. Market participants and the Fed will be watching expectations and the unemployment rate for hints of when inflation could pass 2%.  Rising oil prices, now over $60 per barrel, are another sign that inflation could creep upward and encourage investors to seek higher interest rates.

Over the last decade, beta commodity exposure has offered investors inefficient access to the commodity market, mostly due to front-month roll methodologies and fixed commodity weights. The Dow Jones RAFI Commodity Index is a broad commodity index based on Research Affiliates’ commodity strategy that utilizes price momentum and roll yield to provide (1) dynamic commodity weighting exposure and (2) intelligent futures contract selection.

The Dow Jones Commodity Index, as one of the oldest and most recognizable broad commodity indices, provides diversified broad commodity exposure to 24 commodities. Research Affiliates utilizes the Dow Jones Commodity Index as the starting point to build the Dow Jones RAFI Commodity Index, which is intelligently built to offer equal weight exposure to the energy, metals and agricultural sectors in order to maximize diversification.

The Dow Jones RAFI Commodity Index utilizes a dynamic roll process that considers both roll yield and contract liquidity in selecting which commodity contract to own. In addition, the strategy reevaluates contract selection on a monthly basis to ensure the optimal contract is owned.

Understanding How Roll Yield and Momentum Affect the Dow Jones RAFI Commodity Index

The Dow Jones RAFI Commodity Index utilizes two key factors in constructing its commodity strategy: High Roll Yield and High Momentum.

Roll Yield takes into consideration the shape of a commodity’s futures curve. The shape of the curve can serve as an important indicator of a commodity’s inventory levels. Low inventories can potentially create positive roll yield scenarios, where an investor can theoretically purchase a contract further out on the curve at a lower price than what they could purchase at a nearer-term contract. The strategy is designed to  increase its exposure to commodities with a positive roll yield. Conversely, high inventories can potentially create negative roll yield, where an investor purchases a contract further out on the curve at a higher price than what they could purchase at a nearer-term contract. The strategy is designed to decrease its exposure to commodities with a negative roll yield.

Momentum takes into consideration the price movement of commodities. Imbalances in supply or demand can create positive or negative price momentum which may persist over time. A decrease in supply created by a crop drought, for example, can drive prices higher. Conversely, a new discovery of oil can drive prices lower. The strategy is designed to increase its exposure to commodities with high price momentum.

Why Fundamental Commodities?

• Strong hedge against Inflation
• Broad, dynamic commodity exposure
• Low cost, transparent institutional solution
• Protection against negative roll yields

A Top Performing Broad Commodity Strategy

In 2017, The Dow Jones RAFI Commodity Index finished as the top performing* popular broad based commodity index. In addition, the Index provided superior return/risk statistics relative to both the Bloomberg Commodity Index and the S&P GSCI Index. While past performance is no guarantee of future results, the strategy of the Dow Jones RAFI Commodity Index has thus far proven to be one of the most intelligent strategic beta strategies in the broad commodity space.

*Source: Bloomberg L.P. as of 12/29/2017. All data based on total return figures.

We recently updated our S&P Europe 350 Factor Dashboard, which shows the factor exposures of a number of our European indices (interested parties can sign up here).  Here are some highlights from our year-end report.

Little separated the returns to European core factor indices, but all outperformed

While the extremely low stock-level dispersion contributed to a narrow range of core factor returns – only 8% separated the best from the worst – each of Enhanced Value, Momentum, Quality and Low Volatility outperformed the benchmark S&P Europe 350’s 10.75% total return in 2017.  This was the first calendar year since 2013 that every European core factor index beat the benchmark.  Higher exposures to smaller companies were beneficial to these indices as the S&P Europe 350 Equal Weight Index also beat the S&P Europe 350.  These benefits were in stark contrast to the U.S., where greater exposure to small size, as well as to value, proved a hindrance in 2017.

Exhibit 1: Performance of European Core Factors

Investors got what they paid for in European Dividend Strategies in Q4

Despite concerns earlier in the year that dividend strategies were becoming overvalued, the most expensive European dividend strategy at the end of the third quarter posted the highest return in the final three months of the year as the S&P Europe 350 Dividend Aristocrats rose 0.81%.  Although the S&P Europe 350 Quality was the worst performing index in our report since September, dividend strategies benefitted from greater exposure to higher quality stocks in the fourth quarter; total returns increased monotonically with quality scores.

The 11.04% annual gain in the S&P Euro High Yield Dividend Aristocrats showed the potential benefits of selecting high-yielding stocks with a track record of raising (or maintaining) dividends for at least a decade; the index topped the charts among European equity dividend strategies.

A record-breaking collection on the Bharat 22 ETF (based on the S&P BSE Bharat 22 Index) earmarked a historical event for the Indian ETF market. The issue size pegged at to value INR 8,000 crores) received a nearly four-fold oversubscription, at over INR 31,000 crores.[1] This marked a huge success for the Indian government in its disinvestment program, and they decided to retain INR 14,500 crores and return the balance oversubscription.

The S&P BSE Bharat 22 Index is designed to measure the performance of 22 select companies disinvested by the central government of India. A well-balanced index, it cuts across six sectors, with a stock cap of 15% and a sector cap of 20%. The index was launched on Aug. 10, 2017, with a YTD return of 23.20% (as of Dec. 29, 2017).

Exhibit 1: S&P BSE Bharat 22 Index Returns 

Source: Asia Index Pvt. Ltd. Data as of Dec. 29, 2017. Past performance is no guarantee of future results. Table is provided for illustrative purposes.

The current exponential growth in the Indian ETF market is ushering in acceptance of the passive style of investing. However, it’s still in its nascent stages for this market compared with more developed markets such as the U.S. and Europe. As of Nov. 31, 2017, the global ETF market stood at over USD 4.7 trillion of assets under management, with 7,000 products across 70 exchanges. These statistics favor the U.S. and European markets, which constitute nearly 70% and 16% of the global ETF markets, respectively. The top three global ETF issuers are iShares, Vanguard, and State Street.

In India, the current statistics estimate assets of USD 8 billion, with 67 products[2] and a YTD growth of over 100%; assets were at USD 3 billion at the end of 2016. The growth can be mainly contributed to the inflows in the Bharat 22 ETF and the CPSE ETF, both of which are government initiatives. The growth in assets in the Nifty and SENSEX ETFs are also a result of the boost provided by the introduction of investments in ETFs by pension funds. We see that in India, the government is providing a major impetus to the growth of the ETF space, thereby promoting passive investment.

As always, the active and passive debate is an ongoing one. Since its launch in 2013, the SPIVA^® India Scorecard has aimed to provide some statistical evidence to support the argument. The latest scorecard showcased that in the large-cap equity funds category, over 50% of active large-cap equity funds in India underperformed the S&P BSE 100 in the 1-, 5-, and 10-year periods ending June 2017. Over the three- and five-year periods ending June 2017, the majority of actively managed mid-/small-cap equity funds in India outperformed the S&P BSE MidCap. However, over the one-year period, 56.52% of those funds lagged the benchmark (for details, see the SPIVA India Mid-Year 2017 Scorecard).

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.

Access to market beta and indexed returns is slowly gaining momentum. The benefits of index-based investing—low costs, diversification, flexibility, and access to a theme, sector, segment, or strategy via one vehicle—are making their way into the Indian market and its participants.

The hope is that as the space widens, its opens up more ideas and concepts to index-based investing. While we are still a while away from artificial intelligence ETFs, surely more advanced strategic indices such as factor indices can be adopted by market participants to explore the passive style!

[1]   Source: Times of India, Nov. 21, 2017.

[2]   As of Nov. 31, 2017.

Though the large-caps continue to rally more than the small-caps on the back of their biggest annual outperformance since 1999, small-caps persistently outperform mid and large-caps over longer periods of time, as shown below in the chart and in part 2 of this blog series.

This has been shown by many researchers, most notably by Fama and French, as the small cap premium.  It makes sense since smaller companies may be more nimble, entrepreneurial, and less well followed and invested in by big institutional investors.  However, these companies may also be more risky so quality matters, and as quoted in this post, quality is THE factor that allows the small cap premium to emerge.  This with the annual reconstitution effect are the keys to why the S&P SmallCap 600 outperforms the Russell 2000.

This is the 4th and final part of our blog series containing excerpts from our new paper where we discuss the outperformance of the S&P SmallCap 600 versus the Russell 2000, the performance of the indices compared with active managers, and the case supporting the performance.

WHY THE S&P SMALLCAP 600 OUTPERFORMS THE RUSSELL 2000
The title “Big Things Come in Small Packages” refers to quality over quantity, and often things that have the most value or quality are small.  The S&P SmallCap 600 only has 601 stocks, while the Russell 2000 has 2,010, and the weighted average market cap of the S&P SmallCap 600 is USD 1.77 billion compared with USD 2.05 billion for the Russell 2000 (Source: S&P Dow Jones Indices LLC, FactSet. Data as of June 30, 2017. The Russell 2000 was represented by the iShares Russell 2000 ETF ticker IWM.)

Also, the ROE may contribute to the performance differential, with an ROE of 9.7 for the S&P SmallCap 600 versus 5.9 for the Russell 2000.  Extensive research has been done on the small-cap risk premium and how it has changed over time.  In addition to the research done at S&P Dow Jones Indices on the factors that drive small-cap performance, Asness et al. made a strong case that, once what they define as “quality” is controlled for, a stable and significant small-cap premium emerges.

There are important construction differences between the S&P SmallCap 600 and the Russell 2000. One key difference may be the earnings requirement that the S&P SmallCap 600 implements, which plays an important role in how the index defines quality.

The S&P SmallCap 600 quality effect can be observed in the four-factor regression that adds quality to the three original factors that Fama and French identified: market, size, and value.
Here we are using AQR Capital’s definition of “Quality Minus Junk,” which is based on various
measures of profitability, growth, safety, and payout.  The coefficient to the quality factor is statistically significant for the S&P SmallCap 600 but not for the Russell 2000. This shows the power of quality in driving the outperformance of the S&P SmallCap 600.

The other key methodology difference that drives the outperformance of the S&P SmallCap 600 versus the Russell 2000 is the annual reconstitution effect that dilutes Russell 2000 returns. It, too, has been well documented, not only in a report by S&P Dow Jones Indices showing the significant t-stat of the return difference of the indices, but also by several other well-known researchers.

As winners from the Russell 2000 graduate to the Russell 1000, and losers from the Russell 1000 move down to the small-cap index, fund managers are forced to sell winners and buy losers, thereby creating a negative momentum portfolio.   Jankovskis and Chen, Noronha, and Singal estimated that the predictable nature of the June Russell rebalancing process biases the return of the index downward by an average of approximately 2% per year. Similarly, Chen, Noronha, and Singal found the rebalancing impact to be 1.3% per year.

Together, quality and reconstitution account for most of the S&P SmallCap 600’s outperformance over the Russell 2000. Some of the return difference may also be associated with the liquidity criterion of the S&P SmallCap 600 that is not applied to the Russell 2000. Within the S&P SmallCap 600, a small percentage of stocks, roughly 3%, have a three-month average daily trading volume (ADVT) of less than USD 1 million, compared with about 15% of stocks in the Russell 2000 that have a three-month ADVT of less than USD 1 million.

In conclusion to this series:

• It can be argued that the broad adoption and makeup of the Russell 2000 do not make it more valuable as a performance benchmark or for active to passive replacement.
• S&P SmallCap 600 has outperformed the Russell 2000 over short and long time horizons, through various bear and bull markets, and largely on a monthly and annual basis.
• S&P SmallCap 600 ranks higher than the Russell 2000 in peer group analysis and has provided returns on par or better than active managers in many time periods.
• These results are not a coincidence, given that the S&P SmallCap 600 has quality built into its eligibility criteria.

In a move to increase transparency and liquidity, and to provide lower fees to market participants, we believe the S&P SmallCap 600 should be considered the small-cap benchmark of the industry. Based on its performance, the S&P SmallCap 600 may set the bar higher for active managers and increase the quality of passive small-cap investing.