Indexology^® Blog

Recent SEBI guidelines have highlighted the issue of flawed benchmark usage in the Indian mutual fund industry. Globally funds are required to be transparent and provide complete information around their investment philosophy and within that requirement of transparency. The fund manager is given the leeway to choose their own appropriate benchmark.

First, in this context, it is important to understand the role of a benchmark. Quite simply, the benchmark that an active fund manager chooses mirrors the investment philosophy of the fund. This means that if the fund’s purpose is to invest in largecap stocks, then an appropriate benchmark should be designed to capture only largecap stocks. In this manner, the active manager’s performance can be clearly judged to see if the specific active strategy that has been adopted has value besides a simple index of large cap stocks. The fund manager’s skill in picking stocks will then become clearly evident. Similarly if the fund purports to invest in infrastructure stocks, then the benchmark should be an infrastructure index. Benchmarking against indices like the S&P BSE 100 or the S&P BSE 200, when the investment purpose is far more specific in terms of size, sector, or factors, is an inappropriate use of benchmarks.

Recently, SEBI laid out guidelines defining top 100 listed stocks by total market capitalization, the next 150 as mid cap and the following 250 as small cap stocks. All fund managers are required to choose stocks within these ranges for their various large cap, midcap or small cap funds. There are some buffers built in to avoid large turnover and additional costs, but the idea is to enforce clarity and symbiosis around benchmark and stock selection. A large cap strategy should focus on investing in large cap stocks and should not depend on buying mid cap stocks to give it the alpha over a benchmark. The true value of an investment strategy is not judged against the total market performance but over an index which has similar rules, providing the performance against a generic use of that approach. When choosing funds for investing, investors need to understand the nuances of benchmark selection so that they can make an informed judgement of the value they are paying for and getting over a period of time.

It has not been a great start to the week for the technology sector, with large-cap tech stocks dragging down equity indices across the globe.

With the current media focus on the industry behemoths, suitably arranged into fun acronyms (“FANGs” and so on), investors in the U.S. tech sector might be concerned about the risks of over-concentration.  But is the tech sector the right part of the market to be worried about?

Certainly, the risks of concentration are present in tech: the top five issues account for a shade under half of the total S&P 500 Information Technology index.  As we have argued previously, more concentrated portfolios can have unfortunate characteristics.  Equal-weight indices can help investors manage sectoral concentration risk; they tend to limit a portfolio’s exposure to single issues, and logically outperform as concentration decreases from higher to lower levels.  Should the overall level of concentration within sectors mean-revert, then the current level of concentration – when compared to historical norms – offers a potential guide as to whether an equal- or cap-weighted strategy may be more effective at generating returns.

Which makes it important to notice that the present level of concentration is not unusual for the tech sector.  By the “top-five” measure, the S&P 500 Information Technology index is neither more, nor less concentrated than was typical over the past decade.

In fact, another sector is displaying far greater warning signs.  Concentration in the consumer discretionary sector, while less dramatic in absolute terms, is reaching unusual levels relative to recent history.

Just one issue (Amazon) presently accounts for over 21% of the sector, while the next four (Home Depot, Comcast, Disney and NetFlix) account for another 23%.  Accordingly, while tech may retain the headlines, investors worried about unusual levels of concentration may be better off applying their discretion in other sectors – and perhaps worrying about the CHANDs, not the FANGs!

The SPIVA Latin America Year-End 2017 Scorecard, which tracks the performance of active funds in Brazil, Chile, and Mexico relative to category benchmarks, was recently released. To ensure that the report is as relevant as possible to market participants, the S&P/BMV IRT, the total return version of the S&P/BMV IPC, is being introduced as the category benchmark for Mexico Equity Funds, starting with this year-end 2017 report. The S&P/BMV IPC is widely considered to be the de facto benchmark for Mexican equities, hence the change.

The recent rise in the markets didn’t lead to outperformance by active fund managers against category benchmarks, as the majority of managers underperformed across all categories measured. The percentage of funds outperformed by benchmarks in each category for the one-, three-, and five-year periods are shown in Exhibit 1.

The 2017 year-end report marks the fourth calendar year of publishing the SPIVA Latin America report. To track the historical performance of broad equity fund managers in Latin America, Exhibit 2 shows the average excess return relative to the respective country benchmark on a calendar year basis.

In the strongest bull market years—2016 and 2017—the average performance of the broad equity fund managers trailed the benchmarks in all three markets. The most significant underperformance was seen in Brazil, where the excess return of the manager average was -10.9% in 2016 and -4.6% in 2017. This enforced the notion that fund managers were unable to keep pace with the market in robust market periods.

In 2014 and 2015, which were bear or neutral markets for Latin American equities, fund managers fared relatively better. In Brazil, the average fund performance had positive excess returns in both years. For Chile and Mexico, the average fund performance slightly beat the respective benchmark return in one of the years (2014 for Chile, 2015 for Mexico), while lagging behind in the other year (2015 for Chile, 2014 for Mexico). While active managers did relatively better in periods of low or negative market return years, the magnitude of outperformance was significantly lower than the magnitude of underperformance observed in bull markets.

Behavioral economics has had a transformational effect on the fortunes of millions of people saving for retirement through the introduction of auto-enrollment, default plans, and “save more tomorrow” schemes. In a series of blogs, I explore how insights from behavioral economics could be used to revolutionize ESG investing and facilitate critical finance flows to a more sustainable economy. In part 1, I explored how we could harness the power of inertia to address the intent-action gap for sustainable investing. In part 2, I explore some of the behavioral biases we exhibit about green investing.

The Big Green Elephant in the Room: Why Do We Assume That “Green” Investing Means Sacrificing Returns?

In an era of information overload, competition for our attention causes us to take mental shortcuts leading to errors and biases. As behavioral economists have pointed out, investors are not immune, which could account for the disconnect between science and investor action on climate change. The World Economic Forum’s 2018 risk report highlights the failure of climate change mitigation and adaptation as one of the most impactful and probable issues facing the global economy[1] and the Financial Stability Board asserts that climate is “the most significant” risk investors face.[2] So why is it that in the 2017 CFA Society ESG survey only 50% of respondents admitted incorporating environmental issues into their investment process, and the main reason cited was immateriality?[3]

The big green elephant in the room is the pervasive belief that investing in a way that considers climate requires financial sacrifice. While this can partially be explained by limited knowledge about climate impacts on asset valuations and how environmental issues can be integrated into portfolio construction, behavioral finance provides insights into additional factors at play. The “no free lunch” heuristic is at the root of our automatic response that “green” or sustainable finance requires a returns sacrifice. To lose weight, you must diet, to pass your CFA, you must sacrifice your social life; there is no reward without risk and “good” things (like “green” products) require sacrifice. Even when there is abundant evidence to the contrary, we are less likely to take it into account because of confirmation bias, which is the tendency to prioritize or interpret new information in a way that confirms our existing beliefs. Confirmation bias is stronger for more emotive and deeply entrenched beliefs, which could explain the slower adoption[4] of sustainable finance in markets where issues like climate change are politically polarized, such as the U.S.[5]

Listening to our reflective systems may lead us to a more logical judgement. We are entering an era of unprecedented population growth, placing huge pressure on the finite resource base for food, water, and energy. At the same time, more volatile weather and increasing pollution is depleting our “natural capital” base and governments globally are working to change the cost-benefit dynamics of polluting industries. Against this macroeconomic backdrop, it is logical that more resource-efficient companies and ones more responsive to changing consumer demand for greener products should do better. Indeed, to make the case more powerfully, try reversing the argument—do we believe more resource-inefficient, polluting companies will outperform going forward? A meta-study by Oxford University seems to confirm the thesis. It found that in 90% of cases, environmentally efficient companies have lower costs of capital and superior stock market performance.[6] This is reinforced by a Stanford University study demonstrating that carbon-efficient companies perform better on traditional financial metrics, such as higher ROI, cash flow, and coverage ratios.[7] This data can feed into portfolio construction for both environmentally themed strategies and the greening of “mainstream” strategies. For example, the S&P 500 Carbon Efficient Index tilts rather than excludes companies and has outperformed the underlying index over the past  five-year period—as have versions that exclude fossil fuels, widely perceived to be the economic “losers” of a low-carbon transition. By addressing our cognitive biases, we can remove a key blocker to the flow of capital to a more sustainable economy.

If you liked this blog, you might also enjoy the blog, “Can ‘Being Green’ Deliver Enhanced Returns?”

You can also register to attend the Discover the ESG Advantage event on May 17, 2018, in London.

[1] The World Economic Forum (2018), “Global Risk Report 2018”

[2] https://www.fsb-tcfd.org/

[3] The CFA Institute (2017), “ESG Survey 2017”

[4] Benjamin, Jeff, “Is ESG investing going mainstream?” Feb. 10, 2018.

[5] Dunlap, Riley E., McCright, Aaron M., and Yarosh, Jerry H., (September 2016) “The Political Divide on Climate Change: Partisan Polarization Widens in the U.S.” Environment Science and Policy for Sustainable Development, 58(5): 4-23.

[6]   Clark, Gordon L., Feiner, Andreas, and Viehs, Michael, “From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance,” University of Oxford, September 2014.

[7]   In, S., Young, Park, K., Young, and Monk, A., “Is ‘Being Green’ Rewarded in the Market? An Empirical Investigation of Decarbonization Risk and Stock Returns,” 2017.

If you enjoyed this content, join us for our Seminar Discover the ESG Advantage in
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To continue my last post about the Mexican sovereign debt structure, I will talk about the international debt issued by Mexico. The issuance of government securities in international markets is critical to achieve the Mexican federal government’s funding objectives. The process of the federal government’s securities allocation in international markets is as follows.

1. The federal government agrees with investment banks to issue securities in the market.
2. The investment banks announce the transaction and promote it to investors.
3. Investors purchase, through the investment banks, securities issued by the federal government.
4. Investment banks deliver proceeds from the transaction to the federal government. Simultaneously, the federal government instructs the fiscal agent to deliver the securities to investors.

According to the Mexican Ministry of Finance, unlike domestic debt, there is no timetable for the issuance of securities denominated in foreign currency, since the decision to issue external debt is linked to the public debt strategy as well as to market conditions. Currently, the federal government has debt in U.S. dollars (USD), euros (EUR), British pound sterling (GBP), and Japanese yen (JPY) with 20, 2, 11, and 11 bonds by currency, respectively.

Of note, Mexico has issued three bonds with maturities of 100 years (perpetual bonds). The latest was issued in April 2015 in euros and will mature in 2115; the one issued in USD matures in 2110 and the one issued in GBP matures in 2114. This last bond was actually the first sovereign bond issued by any country in GBP with that maturity, and it had a bid-to-cover ratio of 2.5, which indicates the acceptance of Mexican issuances in global markets.

With USD 68,500 million of outstanding debt in the four currencies, Exhibit 1 shows the structure for these bonds, and we can see that 65% of the total amount is issued in USD. Almost 40% of the total debt has a maturity of more than 20 years and 30% between 5 and 10 years (see Exhibit 2).

The 10 different indices in the S&P/BMV Fixed Income Index series are designed to track the performance of bonds issued in U.S. dollars. Exhibit 3 shows the returns of the S&P/BMV Sovereign International UMS Bond Index and the S&P/BMV Sovereign International UMS Bond Index (USD), with the returns of the former expressed in Mexican pesos and the latter in U.S. dollars.