Indexology^® Blog

The world’s most prestigious cycling race, the Tour de France, begins tomorrow.  The tour lasts three weeks and comprises a series of one-day stages.  Although the main prize – the yellow jersey – is awarded to the rider that takes the minimum amount of time to complete the entire tour, there are plenty of races (and prizes) up for grabs along the way.  Some cyclists aim to prove themselves as the best sprinter, while others hope to wear the polka-dot jersey awarded to the “King of the Mountains” – the fastest cyclist over the tour’s stages in the Alps, Pyrenees, and the Massif Central.

Each rider’s particular talents are important in determining the stages to which their style of racing is most suited.  However, not all talents are rewarded equally: one of the interesting facts about the Tour de France is that the yellow jersey is typically captured by a rider who excels in the mountainous stages.  This is because – generally speaking – there is a greater degree of variation in completion times in the mountain stages than the sprint stages.  Since the overall winner is based on the total time, outperformance in the mountain stages is more valuable than outperformance on the flats, even though there are more of the latter.  Said differently, the greater dispersion in rider’s times during the mountain stages mean the rewards to outperformance are higher compared to stages when everyone sprints at similar speeds to a bunched finish.

The relative value of sprinting and mountain-climbing in the Tour de France has analogies in financial markets.  Over time, investors will encounter calm, smooth gains in some periods, and more challenging, volatile returns in others.  Extending the analogy further, just as performance in the mountainous stages often determines the yellow jersey, the performance of equity portfolios during the most volatile periods goes a long way in determining long-term returns, because there are typically greater differences between the relative winners and losers during periods of elevated volatility.

As we showed in our recent practitioner’s guide, low volatility indices tend to underperform in less volatile, rising markets and outperform in more volatile, falling markets.  The table below summarizes this empirically through the monthly “capture ratios” for a number of our low volatility indices.  Each monthly downside capture ratio is less than one, meaning the low volatility indices were typically better insulated in months when their benchmark fell.  The higher upside capture ratios indicate that the low volatility indices stayed closer to the pack when the benchmark rose. 

Exhibit 1: Low Volatility Indices Have Provided Downside Protection And Upside Participation

Source: “Low Volatility: A Practitioner’s Guide”; Edwards, Lazzara & Preston (2018), S&P Dow Jones Indices LLC.  Data based on monthly total returns from January 2001 to April 2018.  Past performance is no guarantee of future results.  Table is provided for illustrative purposes and reflects hypothetical historical performance.

Just as the race for King of the Mountains is a key determinant of who takes home the yellow jersey, the pattern of upside participation and downside protection offered by low volatility indices can help to explain how many of them have recorded market-beating performance in the longer term, historically.  And in a year when momentum, growth and information technology have dominated headlines, low volatility may presently offer a way to avoid a crowded finish.

Index derivatives exist for all asset classes, and over time their use has grown exponentially for a variety of purposes. Still, many myths abound that their chief function is for speculative activity. The ability to leverage by investing a small amount to gain exposure to a much larger investment is the key benefit of index derivatives. While index futures have a symmetric impact on portfolio returns, index options can have an asymmetric impact. Both are valuable, cost-efficient tools for a number of reasons for a portfolio manager.

A large exposure can be obtained in a portfolio with a small amount of margin investment, and the potential for returns is magnified with a far smaller investment, making them quite cost-effective. Their liquid nature and ease of trading make them the number one tool for hedging and managing exposure. Derivatives can cover for downside risk when large exposure exists in a portfolio long on equities. On the other hand, if an investor has shorted a large number of single securities, then a single index call option can provide a great hedge against an inverse market move. If an investor has large cash holdings that he or she wants to use for buying stocks after further research, a quick and easy way to deploy the funds is to go long on an index futures contract or buy a call option. This provides the exposure the investor is ultimately looking to gain, buys time to do the research, costs far less, and manages the price impact of large trading in a short time frame. Small purchases over time would reduce the effect over prices and avoid creating a market impact.

Similarly, when a large number of securities needs to be sold off, buying an index future gives time to ease in the selling over time and to dampen price pressure. As cash positions are built over time, the index future maintains the overall security exposure until further investment decisions are made. This approach makes sense for active and passive investors, where large trades can be counterbalanced with the use of index futures or options bought at a low cost by the investor to avoid having large price-affecting shifts in exposure. Another interesting use of derivatives is when the portfolio has a gap in exposure to a particular sector or size. For example, if the portfolio lacks small-cap investments or exposure to a specific sector, index futures or options can be bought to cover those gaps rather than trading single small assets in this space at a much higher trading cost. In sum, index derivatives are cost-effective and are a great tool for tactical use of assets in a portfolio. Trading them for speculative activity is actually riskier and a less-effective use of this financial tool.

Small caps are outperforming large caps (S&P 600 (TR) – S&P 500 (TR)) in H1 2018 by the most in eight years, since H1 2010, from growing  concerns over rising tariffs and general U.S. foreign trade policy. In the past four months, the smaller companies have outperformed larger companies by 10.1%, contributing to the 5th biggest realized small cap premium in the first half of any year in history.

The smaller cap stocks are less sensitive to international relations generally from the higher percentage of revenue generated in the U.S., though they are still impacted by sector fundamentals and the percentage of exports of foreign output since the U.S. economy is largely driven by consumer spending.  Overall, U.S. small caps in the S&P 600 generate nearly 80% of revenue domestically, whereas U.S. large caps in the S&P 500 only generate just over 70% domestically.  However, this varies by sector which can explain some of the small cap premium.

For some sectors like financials and industrials that are showing relatively large small cap premiums, the revenues generated from the U.S. are significantly higher for small caps.  For example, financials have 17% more of revenues coming domestically, driving the small caps to outperform by 11% year-to-date through Jun. 29, 2018 that has been helped by rising interest rates,  growth, inflation and the rising dollar.  Historically, financials have done best with GDP growth of any sector, rising on average 6.9% for every 1% rise in GDP growth.

Industrials, one of the sectors that may be most impacted by fears of tariff and trade, also have a relatively greater portion of revenues, 14% more, coming domestically for small caps than large caps.  The rising dollar increases the small cap industrials 84 basis points on average for every 1% dollar increase, whereas the large caps only rise 67 basis points for the same dollar move.  Also for every 100 basis point rise in interest rates, the small cap industrials have risen 8.6% on average versus just 4.8% for large cap industrials.  The result has been a 10% small cap premuim for the sector this year.

However, for some sectors like health care, consumer staples and energy, the industry fundamentals have been more powerful for the small cap outperformance than the percentage of revenues coming domestically for the small caps versus the large caps.  For example health care and consumer staples each has nearly the same percentage of revenues generated domestically as internationally but the small cap premiums have been high of 29% and 15%, respectively.  Small health care companies are outperforming large caps in health care from increased expectations for acquisition of smaller companies, stronger innovation from smaller companies and that smaller companies may be more immune to concerns about regulatory pressures in healthcare.  Also in energy, the performance between sizes has been nearly even despite the gains in oil price.  This is since oil hedging by the larger companies is more prevalent than in smaller companies, offsetting some of the gains from the rising oil and domestic tailwinds.

Additionally, consumer staples have shown a strong small cap premium despite similar portions of revenue generated domestically despite size. This seems to be driven mainly by fear of uncertainty in the market, making it the second best performing small cap sector in June.  It outperformed the more economically sensitive consumer discretionary sector in two consecutive months for the first time since July and Aug 2017, and the small cap consumer staples have been outperforming the small cap consumer discretionary by 11.2% more than the large cap consumer staples have been outperforming the large cap consumer discretionary.  This is the biggest consumer staples -discretionary differential between the sizes in a quarter since Q2 2001, and the most in 3 months since the period ending in Nov. 2015.  Some may view this as a bearish signal.

Moreover, the consumer staples rise more historically with rising rates than consumer discretionary does considering more expensive financing for consumers as they make optional purchases.  For every 100 basis points rise in rates, the small consumer staples rise on average 7.2% versus just 2% for large caps, and the consumer discretionary small caps rise 6.2% on average as compared to the 5.5% gain in the large caps on average.  The large cap consumer discretionary sector is one of the few sectors that consistent outperforms its small cap counterpart, likely helped by the purchasing power of large companies in the sector that may be adversely impacted by higher tariffs or  trade restrictions.

Lastly, in June seven of the sectors added onto their small cap premiums for total returns of 0.6% for the S&P 500, 1.1% for the S&P Small Cap 600 and 0.4% for the S&P Mid Cap 400 for the month.  This added onto the year-to date gains of 2.6% for the S&P 500, 9.4% for the S&P Small Cap 600 and 3.5% for the S&P Mid Cap 400, and again widening the small cap premium this year to the 5th biggest ever.

General elections (president, senate, and chamber of deputies) are around the corner. The eyes of every Mexican and many people around the globe are on the Mexico-Brazil match of the World Cup—wait, that is another story.

Nobody knows what the outcome of the elections will be. We have seen different events where the polls were wrong (for instance, Mexico beating Germany in the match on June 17, 2018). However, the market incorporates these expectations in many ways, one being the currency. Exhibit 1 shows how the Mexican peso performed before and after the past two elections (2006 and 2012) compared with the U.S. dollar.

We can see that before the elections, the tendency in 2012 and 2018 was similar, and after the elections in 2006 and 2012, the tendency was an appreciation of the currency. We know that the elections are not the only factor moving the Mexican peso—for example, in 2018 due to the NAFTA, it has shown a lot of volatility.

Exhibit 2 shows how the S&P/BMV Sovereign International UMS Bond Indices, which are designed to measure the performance of Mexican government securities issued outside of Mexico in U.S. dollars, performed before and after the elections.

In 2018, the elections have not been the only factor affecting the Mexican peso. The Mexican Central Bank has followed the U.S. Fed’s policy decisions and moved up the overnight interbank interest rate 50 bps to stand at 7.75%. In 2012, the rate was steady at 4.50%.

Any outcome on Sunday, June 30, 2018, will surely have an impact on Mexico. By nightfall, we may have a newly elected president, but at 9:00 am (local time) on Monday, July 2, 2018, Mexico will play against Brazil in the World Cup. Looks like attention to the news to see how the elections went will have to be shared with the match!

Small caps have materially outperformed large caps in 2018, with the S&P SmallCap 600 outpacing the S&P 500 7.80% to 2.58% between Dec. 29, 2017, and May 25, 2018.¹ Below, I highlight what I believe to be the drivers of small-cap returns this year, and why I believe the trend could continue.

Tax cuts have benefited small caps. In the three years ending December 2017, the companies in the S&P SmallCap 600 had an average effective tax rate 4.3% higher than the S&P 500.¹ Investors looking for stocks that may experience improved profitability due to US tax reform seem to have turned to the small-cap sector.

Trade tensions may favor small caps. 2018 has been a year of trade tensions, but smaller companies tend to have less overseas exposure than larger companies. S&P SmallCap 600 companies generated 78.8% of their revenues from the US compared to 70.9% for the S&P 500.² The difference was even more dramatic in the growth style box, where S&P SmallCap 600 Growth companies produced 80.6% of their revenue from the US compared to 65.1% for S&P 500 Growth companies.² The recent political tensions in Italy and Spain and the potential threats to economic growth in the eurozone may prompt investors to reduce their overseas exposure and benefit small caps relative to large caps.

The trend in earnings estimate revisions favors small stocks over large. Earnings estimate revisions have been strongest in the small-cap sector. Forward earnings estimates for the S&P SmallCap 600 have risen by more than 28% compared to 18.7% for the S&P 500 over the past six months.³

The US economy has shown relative strength. More recently, the US economy has continued to display strong growth, while economies in Europe and Asia have softened. The IHS Markit Eurozone Manufacturing PMI has declined from a peak of 60.6 in December 2017 to a recent low of 55.5 in May 2018, while the Nikkei Japan Manufacturing PMI has eased from a January 2018 high of 54.8 to a recent low of 52.8 in May.⁴ In contrast, the IHS Markit US Manufacturing PMI was just below its cycle high at 56.4 in May.⁴

Investors may be choosing small caps over emerging markets for their risk sleeve. Investors may  have become uneasy over emerging markets due to geopolitical tensions (the Turkish lira crisis, instability in Venezuela, and Russian sanctions, for example), a rising 10-year Treasury yield, and a firmer dollar that has rallied from its February low. The risk sleeves of portfolios may have tilted toward small caps.

Small-cap valuation has become more attractive. Some see better value in small caps as the price-to-earnings (P/E) ratio has compressed on the S&P SmallCap 600, suggesting that small caps have cheapened in recent years. On a forward earnings basis, the S&P SmallCap 600 is currently trading at 20.1 compared to 17.0 for the S&P 500. The ratio of 1.18 is down from a peak of over 1.33 in July 2009.⁵

The technical picture is supportive. Using technical analysis can be a risky proposition, but the technical set up of the S&P SmallCap 600 looks bullish, in my view. The index has broken out of consolidation to the upside in a near textbook ascending triangle. The target of the triangle projects over 1075 based on the depth of the formation (this measure is approximate – this is an art not an exact science). Another target would be the top of a channel formed off the lows of the triangle. This is a moving target, but higher than current levels and consistent with the 1075 level.  However, the small-cap sector appears to be overbought in the near term given the Relative Strength Index was recently over 73, but pullbacks to the hold highs in the 980 area may have the potential to provide support. Old resistance levels tend to become supportive (the top of the triangle).

1 Source: Bloomberg L.P.

2 Source: S&P Dow Jones Indices, “ How Global are the S&P 500, the S&P Midcap 400, and the S&P Smallcap 600 Style Indices?” Feb 28, 2018.

3 Source: Bloomberg, L.P. as of May 24^, 2018

4 Source: IHS Markit

5 Source: Bloomberg, L.P. as of May 31^, 2018