Indexology^® Blog

As a leading index provider with clients and customers around the world, S&P Dow Jones Indices regularly launches new indices.  Just like our children, we try to love them all equally.  Every now and then, however, a particularly exciting new index comes along.  Last week, our global equities group launched a potentially important new benchmark for global small cap investors, the S&P Global SmallCap Select Index Series.  This series is built on the basic principle that filtering out junk makes a big difference in small caps, and extends this concept globally.

Who needs earnings?  Contrary to the rumblings out of Silicon Valley, profitability is not a bad thing.  With small companies, earnings may be particularly important to long term returns, and trimming out poor performers can substantially improve investment performance in small cap portfolios.  For example, the S&P SmallCap 600^®—which includes positive earnings criteria—has outperformed the broader Russell 2000 Index (with lower volatility) for more than 20 years.  This outperformance has been examined in some detail by earlier S&P DJI research, but this is the first time that S&P DJI has extended the concept in a consistent way to the global small-cap universe.

The S&P Global SmallCap Index (representing the portion of the S&P Global BMI made up from the smallest 15% of companies in each country by capitalization) provides the starting point for the “Select” series.  In order to become a member of the Select, companies must meet additional size and liquidity criteria, and must also post two consecutive years of positive earnings.  Around 5,000 of the 8,321 global small cap companies, accounting for around 4/5ths of the free-float market capitalization, were included in the Select index at the most recent rebalance.

The potential benefit of the methodology is demonstrated in the chart below, where we see consistent excess returns from the SmallCap Select series vs. its parents.  On a rolling five-year basis, for both the Global and Global Ex-U.S. versions of the small cap indices, the Select index outperformed most of the time, averaging around 1% per annum in excess returns.  A simple profitability screen, in other words, would have generated substantial excess returns relative to the unscreened small cap universe.

The series offers a global index as well as regional indices which can be further broken into country indices as needed.  Currently, the universe includes:

1. S&P Global SmallCap Select Index
2. S&P Global ex-U.S. SmallCap Select Index
3. S&P Developed ex-U.S. SmallCap Select Index
4. S&P Emerging SmallCap Select Index
5. S&P/ASX Small Ordinaries Select Index

These indices could change the game for global small-cap investing and for benchmarking the performance of active small cap portfolios.  Those who take the time to look could discover a way to improve results in small caps.

In the first seven trading days of 2019, the S&P 500 returned 3.6%, its 12th best start on record since 1928 and best since 2003.  Also, the S&P MidCap 400 and S&P SmallCap 600 surpassed large caps by posting their best gains ever to start a year.  Lastly, more than half the segments by sector, size and style have posted their biggest gains in history.

The S&P 500 posted five consecutively positive days, ending January 10, 2019, returning a total of 6.1%.  The last time the S&P 500 returned five consecutively positive days was ending September 14, 2018, but the cumulative return was just 1.2% then.  Five straight days of positive returns has happened 4% of the time since January 4, 1928, but in just 44 prior instances or 0.2% of the time, has the return been bigger than now.  The last time the five day return (with all positive days) was bigger than 6.1% happened in the streak ending July 13, 2010, returning 6.5%.  The last January that had a five day winning streak this big happened in January 1987 that occurred in the first five trading days of that year and returned 6.2%.

Across all the size, style and sector segments, 22 of 42 total posted their best start to any year in the first seven trading days.  The S&P SmallCap 600 and S&P MidCap 400 each posted their best start in history, gaining a respective 6.4% and 5.9% with value outperforming growth.  Eight of eleven small cap sectors, six of eleven mid-cap sectors, and just two of eleven large cap sectors started strongest this year. Energy and consumer discretionary each had their best start despite size.

The leading sectors may be currently influenced by the falling dollar and trade negotiations.  Historically the falling dollar is best for mid-caps, since a falling dollar may help mid-caps grow internationally as they are big yet nimble enough to take advantage of new opportunities overseas.  However, energy is particularly sensitive to the dollar drop since oil is priced in dollars.  Though all sizes of energy performed well with oil’s recent rise, mid- and small-cap energy returned more than double its large cap counterpart, which is not surprising with rising oil as larger companies hedge more against the price volatility.

The S&P SmallCap 600 and S&P MidCap 400 respective gains of 6.4% and 5.9% to start the year outpaced large caps gain of 3.6%, which is historically typical in early bull markets.  However, it may be too soon to tell whether the Fed has more influence on the stock market than other unresolved issues both domestically and abroad like trade tensions, Brexit and the partial government shutdown. Historically in a rebound, the financial sector and real estate sector performed best but this bounce is led by energy, consumer discretionary, industrials and materials, showing the move may be more focused on issues abroad – in addition to interest rate comments from the Fed.  If the dollar rises more, small-caps have done historically best from their high percentage of domestic revenues, but energy might be put under pressure with the rising dollar, especially in the less hedged mid-and small caps.

Recent anxiety about an imminent recession sparked discussion of inverted yield curves and falling long term interest rates, The slope of the yield curve – the difference between the yield on the five or 10 year treasury note and a short term instrument like three month T-bills – may signal a recession. The chart shows the slope of the yield curve and recession dates since April 1953. The slope moved below zero as each recession began.

The idea of using the yield curve to predict the economy has a long history. Other combinations of treasury notes and bills show the same patterns; the choice of five or ten year notes and three-month bills gives the longest data history. There is some theoretical backing: when consumers and investors fear a recession is coming, they are likely to move assets into intermediate and long-term bonds as a hedge against future economic difficulties. This asset re-allocation may raise bond prices, lower yields and dampen the stock market. (See “Forecasts of Economic Growth from the Bond and Stock Markets” by Campbell Harvey, Financial Analysts Journal, September-October 1989)

While the first chart suggests that the yield curve is a useful predictor, the next chart shows that the stock market gives less accurate predictions. The market moves associated with the recessions in 2000-2001 and 1990-1991 were largely after the recessions. The economy kept on rolling despite the 1987 market crash.

The financial markets are not the only thing driving the economy – changes in employment matters.  The last chart shows the weekly Initial Unemployment Claims series published by the Bureau of Labor Statistics. When economic activity begins to fade companies respond by cutting hiring and letting people go. Jobs-losers file for unemployment. A rule of thumb is an initial claims number above 400,000 is cause for concern while a figure under 300,000 signals an unusually strong economy.

With all these, what is the risk of a recession near term? Initial claims suggest there is little to worry about while the yield curve signals some caution.

2018 ended on a sour note for the S&P 500^®, as the index declined by more than 9% in December alone. The drop-off resulted in the first negative calendar year return (-4.38%) for the S&P 500 (TR) since the financial crisis (2008). Meanwhile, the S&P 500 Dividend Aristocrats^®, which is designed to measure the performance of S&P 500 companies that have increased their dividends for the last 25 consecutive years, fared relatively better in 2018 but still ended in the red (-2.73%). The S&P 500 Dividend Aristocrat’s outperformance of the benchmark led us to explore the downside protection characteristics of dividend growth strategies relative to the broad equity market. In addition, we attempt to answer the question of whether outperformance in a down year is typical for dividend growth strategies, or if 2018 was an anomaly.

Since year-end 1989, there have been six calendar years of negative performance for the S&P 500—and in all six years, the S&P 500 Dividend Aristocrats outperformed the equity benchmark by an average of 13.28%. In fact, the S&P 500 Dividend Aristocrats produced a positive total return in three of those years (see Exhibit 1).

To see how the S&P 500 Dividend Aristocrats stacks up against the S&P 500 in shorter periods, we next look at historical monthly returns. First, we classify all months into up and down months based on the S&P 500’s returns. We then compute the monthly hit rates (batting average) and average excess returns of the S&P 500 Dividend Aristocrats compared to the S&P 500.

The S&P 500 Dividend Aristocrats outperformed the S&P 500 53% of the time, by an average of 0.16%. When isolated to down markets, the S&P 500 Dividend Aristocrats outperformed over 70% of the time and by an average of 1.13%. In up markets, the S&P 500 Dividend Aristocrats underperformed 56% of the time, but at a lower average magnitude (-0.34%). This shows that the S&P 500 Dividend Aristocrats has delivered downside protection in months when the S&P 500 lost ground.

Stemming from the results in Exhibit 2, our final question is: does the magnitude of return influence return differentials? To answer this question, we broke out the historical monthly returns of the S&P 500 from -10% to 10% in 1% increments. We then computed hit rates (light blue diamonds, primary axis) and average excess returns (navy columns, secondary axis) for each group in Exhibit 3.

We are able to confirm that the lower the return of the S&P 500, the better the relative performance was for the S&P 500 Dividend Aristocrats. We see the batting average was typically better for the more negative months than the less negative months. Additionally, we observe that the average excess return over the S&P 500 was higher in the most negative months. Since 1989, the S&P 500 has lost 5% or more in 31 out of 348 months (~9% of the time). In these months, the average excess return for the S&P 500 Dividend Aristocrats was 2.46%, with a hit rate of 81%. The median excess return was of similar magnitude (2.32%); therefore, the results were not skewed by only a few months—rather, there was consistent outperformance.

Based on the results, we have demonstrated that the S&P 500 Dividend Aristocrats outperformed the S&P 500 in down markets by an average of 1.13% per month. The results were more evident when the S&P 500 lost the most, with the S&P 500 Dividend Aristocrats outperforming by an average of 2.46% when the S&P 500 lost at least 5%. The underlying reasons why the S&P 500 Dividend Aristocrats outperforms will be discussed in another post.

To learn more about dividend growth strategies, register here for an upcoming webinar on Thursday, January 10^th featuring S&P DJI’s Aye Soe, CFA, Managing Director, Global Research & Design.

As the ball dropped this New Year’s Eve, most investors were more than happy to bid adieu to what proved to be a volatile end to 2018. The fourth quarter began with the October sell-off, which was just the start of a highly volatile quarter. The S&P 500^® fell almost 7% in October alone, with losses accelerating into the end of the year during what is likely to be one of the worst Decembers on record.

Large equity market drawdowns such as these remind us of the importance of portfolio diversification. Traditionally, this has been achieved by building multi-asset portfolios that combine complementary asset classes such as stocks and bonds.

First generation multi-asset strategies, exemplified by a 60/40 allocation, seek to create balanced portfolios by diversifying across asset classes in fixed proportions. However, this technique does not maximize diversification benefits because it ignores the risk contribution of each asset class.

The recognition of these shortcomings led to the development of a class of investment strategies called risk parity, which seeks to equalize the risk contribution of each asset class. The primary goals of risk parity are to provide a smoother return profile and minimize losses from equity market drawdowns like we saw in the fourth quarter of 2018—so let’s examine how they performed.

While each of these portfolios also posted negative returns, the losses seen in the 60/40 portfolio and the S&P Risk Parity Indices were modest compared with the large drawdowns witnessed in equity markets (see Exhibits 1 and 2). As one might expect, the “risk-balanced” S&P Risk Parity Indices outperformed the global 60/40 portfolio across each volatility target.

Now let’s take this analysis to the next level and examine the asset class performance attribution within these indices (using excess returns). The S&P Risk Parity Indices comprise three asset class sub-components: equities (broad indices across the U.S., Europe, and Asia), fixed income (sovereign bonds across the U.S., Europe, and Asia), and commodities (energy, softs and livestock, grains, and metal sub-sectors).

The equity component drove the bulk of the negative performance, contributing a loss of 4.72%. The fixed income component offset some of the negative equity performance, contributing a gain of 2.79%, with the majority of the positive performance coming in December. The commodities component did not fare as well, contributing a loss of 2.97%, which in essence canceled out the diversification benefit provided by fixed income.

Q4 2018 may not be a stellar example of the power of diversification, but it underlines the need to maximize the so-called “only free lunch in finance.” When equities are given an outsized risk allocation, equity market losses like those seen in Q4 2018 will dominate portfolio performance. However, when each asset class is given equal footing, the diversification benefits have a better chance of shining through. Given the opportunity, investment strategies such as the S&P Risk Parity Indices have the potential to help smooth out drawdowns and improve risk-adjusted returns.