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How Much Popularity Can Low Volatility Stand?

The Fed’s QE Dilemma

Not ALL Weights are EQUAL: Why Brent isn't Heavier than WTI

3 Reasons Companies Issue Preferreds

Core / Satellite Investment Strategies: Don’t Forget The Beta!

How Much Popularity Can Low Volatility Stand?

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Craig Lazzara

Managing Director and Global Head of Index Investment Strategy

S&P Dow Jones Indices

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The low volatility anomaly — i.e., the tendency for low-volatility or low-beta portfolios to outperform market averages — has been the subject of at least 40 years of academic research.  Given its challenge to what “everyone knows” about risk and return, it’s a fertile field for both professors and practitioners, some of whom recently characterized “the long-term outperformance of low-risk portfolios [as] perhaps the greatest anomaly in finance.”

But anomalies, especially ones that suggest higher return and lower risk, attract investor dollars, and enough investor dollars often spell the end of anomalies.  It’s been suggested that “the low-volatility anomaly may [be] eliminated by its popularization.”

So how much popularity can low volatility stand?  Before we can suggest an answer to this question, we have to understand the source of the low volatility anomaly.  Perhaps the simplest and most intuitive explanation comes from behavioral finance, specifically from the cognitive bias that behavioral economists call the “preference for lotteries.”  Their argument is that no rational person would ever buy a lottery ticket, since the expected return of such a purchase is negative.  But billions of lottery tickets are sold all over the world every day.  Why do so many people behave in a way that classical economics can only regard as completely irrational?  The behavioral argument is that some people are willing to risk a known amount of money in exchange for the possibility, however slim, of a gigantic payoff.

If this happens in a game of pure chance, how does it apply to financial markets?  The stock market’s lottery tickets are the stocks of highly volatile, often young and untested, companies.  Ultimately, they may not amount to much, but one of them could be the next Apple or Google.   Some investors are willing to pay up for the chance of that sort of large reward — in effect buying volatility for volatility’s sake.  Low volatility strategies benefit by avoiding other investors’ volatility-seeking behavior.  We can estimate the capacity of low vol if we can estimate the extent of of volatility seeking on the other side of the trade.

Last week witnessed the much-anticipated initial public offering of Twitter, Inc., a young and volatile company if ever there was one.  The IPO price was $26; the stock closed its first day of trading (November 7) at $44.90, which implied a total market value of approximately $25 billion.  For illustrative purposes, let’s assume that $26 is a sober estimate of TWTR’s fair value (after all, the presumably well-informed selling shareholders were willing to sell there).  Then arguably the $18.90 first day’s appreciation represents the action of volatility-seeking investors.  That’s 42% of TWTR’s closing first-day valuation, or better than $10 billion.

Granted, this is a simple example with some perhaps-unrealistic assumptions.  But it gives us at least a rough gauge with which to answer our question about the capacity of low volatility strategies.  One company, in one day, produced $10 billion in volatility-seeking market value.  That’s more than the total market value of the two largest U.S. low volatility ETFs.  Whatever the ultimate capacity of low volatility strategies is, we’ve got a long way to go.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

The Fed’s QE Dilemma

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Bluford Putnam

Managing Director and Chief Economist

CME Group

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The US does not have any measurable inflation pressure now nor has it had any over the last 20 years.  The core personal consumption price index, used as the benchmark for inflation by the Federal Reserve (Fed) has been in the 1.25% to 2.5% zone since 1994, averaging about 1.75% for the last 20 years, and drifting down to an average of about 1.25% over the last six months.  This has been true despite three bull markets in equities – the technology-led rally of the 1990s, the housing boom of the early 2000s, and the post-2008 financial crisis QE-induced bull market.  Not even the last five years of historically accommodative monetary policy with a near zero federal funds rate and massive central bank asset purchases has been able to kindle inflation pressure.  The same is true in Europe, where there are fears of sliding into deflation.  And in Japan, the Government is struggling to break the back of the country’s deflationary psychology and eke out a 2% inflation rate by 2015.

Even in the housing boom of 2003-2007, when US bank loans and leases were growing at around an 8% rate, core inflation never breached 2.5%.  With bank loans growing at only a 3% pace over the last several years, it is hard to see inflationary pressures gaining any traction.  The Fed may be buying assets at a record pace of over a trillion dollars per year at an annualized rate ($85 billion per month), but the Fed also pays 0.25% interest on both required and excess reserves, giving banks a tiny, yet positive premium over the effective federal funds rate in the open market.  Moreover, large corporations are sitting on record cash hoards in no small part because the long-run environment is so uncertain.  And, the US Congress with its brinkmanship over the debt ceiling and willingness to shut the government down probably should get a reasonably large share of the blame.  In short, much faster, probably +10% annual growth, in commercial and industrial bank loans is probably a pre-condition for the development of inflationary pressures in the US.

Then there is the matter of the reinforcing effect from the currency markets.  A weak dollar helped to feed inflation in the 1970s, and a strong dollar help cure it in the first half of the 1980s.  With all the major industrial countries in the same boat, with less than optimal economic growth, and near-zero short-term rates, no currency trends have developed to push inflation higher (or lower).  In Japan, round one of Abenomics saw the yen depreciate 20% from below 80 yen/$ to the 100 yen/$ range, but the yen has been quite stable since that early move ended last April.

The Fed’s dilemma is to reconcile the lack of evidence that its QE programs created jobs or moved the needle on inflation, with the fact that the size of the central bank’s balance sheet is getting quite worrisome.  Before the 2008 financial crisis, the size of the Fed was around 6% of nominal GDP, and now it is about 25% and climbing.  The next three FOMC meetings, on 17-18 December 2013, 28-29 January 2014, and 18-19 March 2014, are not only likely to see Ben Bernanke hand the gavel over to Janet Yellen, but also see the internal debate become much more rancorous concerning the appropriate size and role of the central bank.  More than a few Fed Governors and regional Fed Presidents are likely to argue that the central bank needs to recognize the limits of what it can accomplish, given the headwinds from fiscal tightening, Congressional-induced economic uncertainty, and a slower growing labor force that is aging as well.  All of these concerns will make for an exciting debate and are likely to lead to more volatility in both US Treasury bond and equity markets than have been the case during the QE era when volatility has been suppressed artificially.

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only.  The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions.  This report and the information herein should not be considered investment advice or the results of actual market experience.

S&P Dow Jones Indices is an independent third party provider of investable indices.  We do not sponsor, endorse, sell or promote any investment fund or other vehicle that is offered by third parties. The views and opinions of any third party contributor are his/her own and may not necessarily represent the views or opinions of S&P Dow Jones Indices or any of its affiliates.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Not ALL Weights are EQUAL: Why Brent isn't Heavier than WTI

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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2014 is just around the corner now and the new weights for both the DJ-UBS CI and S&P GSCI have been announced. While the index weightings follow the methodologies, there are questions around the weights of two particular commodities, Brent crude oil and WTI crude oil. The interest comes from the fact that they are the most heavily weighted commodities across the two indices and there has historically been a popular spread trade between the two, since theoretically they should trade similarly given their qualities.  However in the past few years, there has been a build-up of WTI from the recent surge in US production, causing the price differential to increase where Brent has been more expensive than WTI.

Source: S&P Dow Jones Indices. Data from Nov 2003 to Nov 7, 2013. Past performance is not an indication of future results. This chart reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with backtested performance
Source: S&P Dow Jones Indices. Data from Nov 2003 to Nov 7, 2013. Past performance is not an indication of future results. This chart reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with backtested performance

In 2013, the WTI- Brent spread narrowed from improving transportation and increased midstream infrastructure to enable crude to be transported to coastal refiners. Also, according to the EIA, refiners have been running at higher rates, driving up the demand for WTI.

EIA Refiner Capacity

The WTI-Brent spread has historically traded near par and reached near par at points earlier this year. However, given the structural change of significantly more oil being produced from the U.S. (with projections of continued future growth), many market participants expect Brent to be priced at a premium to WTI. For example, the EIA, noted in its monthly report titled “Short Term Energy Outlook” that it expects a spread of ~$6 per barrel in 2014. They also noted that the Brent-WTI price spread may be influenced by the balance between future growth in U.S. crude production and the capacity of crude oil infrastructure to move that crude to U.S. refiners.

So, the question is, why are the 2014 target weights in the DJ-UBS CI and S&P GSCI for WTI still heavier than for Brent?

Simply stated, the reason WTI is still heavier than Brent is because the data used to calculate the weights is based on historical five year averages. Both indices use world production and liquidity in the weighting calculations, though the factors are applied in a slightly different way for each index.

For example, in order to construct the weights of the commodities in the DJ-UBS, a ratio of 2:1 of liquidity: production is applied.  The liquidity is a based on annual volume data for the five years up to and including the year prior to the calculation period. For example, the target index weights in 2014, which are calculated in 2013, include years 2008-2012.

For each commodity, a relative liquidity is assigned by taking the ratio of the individual contract liquidity versus the total index liquidity. The production also uses a 5 year average of US dollar adjusted production based on the latest common date of production across all commodities. The 2014 index weights are calculated in 2013, so the data spans from 2006-2010.  The weighting process then adjusts the data into similar units as in the futures contracts (like barrels for oil). Finally the average settlement prices for the first day of every month are converted into US dollars and multiplied by production. The relative production, like relative liquidity is the result divided by the overall index production. Finally, limits are enforced so that no single commodity is over 15%, no derivative commodities (like Brent, WTI, Heating Oil and Unleaded Gasoline) are greater than 25% combined, and no group (Energy) is greater than 33%.

The S&P GSCI uses a similar methodology for data collection, though the application for weights is slightly different that results in dramatically different target index weights than for the DJ-UBS CI, especially since there are no weight limits for the S&P GSCI.  The S&P GSCI applies a relative world production weight to each component (a component may be more than one commodity: for example, petroleum includes Brent, WTI, Gasoil, Heating Oil and Unleaded Gasoline.) There are 18 components in the S&P GSCI that are constructed from 24 individual commodities. After the relative world production is calculated, a relative liquidity adjustment is applied that drives the weighting difference between commodities of the same component, like WTI and Brent.

The resulting impact on the indices has been a weight that is shifting out of WTI and into Brent, though Brent has not taken over WTI yet. Please see the chart below for the historical weightings since Brent was added into the DJ-UBS CI.

Source: S&P Dow Jones Indices.
Source: S&P Dow Jones Indices.

The next common question is what impact will this have on the market?

Fortunately or unfortunately, this question is not as predictable as the former question. By estimated assets tracking published for year end 2012, which were approximately $75 billion for the DJ-UBS CI family and approximately $80 billion for the S&P GSCI family, that implies (given all else constant) from the 2011 rebalance through the 2014 rebalance, a total of about $23.4 billion is removed from WTI and about $21.2 billion is placed into Brent, where roughly $2.6 billion is set to move during the 2014 rebalance. 

Finally, does this mean Brent will increase in price and WTI will drop?

If we look at the 2013 rebalance period (Jan 8-14, 2013 for the S&P GSCI, and Jan 9-15, 2013 for the DJ-UBS CI) for some guidance, we notice that approximately $9.3 billion flowed out of WTI and $8.1 billion into Brent based on estimated assets tracking the flagship indices, DJ-UBS CI and S&P GSCI. However, due to the expansion of the Seaway Pipeline in January 2013 to enable more WTI to flow from Cushing in Oklahoma to the Gulf Coast refiners, the S&P GSCI (WTI) Crude Oil increased 57 basis points over the rebalance period when assets tracking flowed out. At the same time the S&P GSCI Brent experienced a 1.39% loss despite the inflows.

 

 

 

 

The posts on this blog are opinions, not advice. Please read our Disclaimers.

3 Reasons Companies Issue Preferreds

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Aye Soe

Managing Director, Global Head of Product Management

S&P Dow Jones Indices

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Companies may issue preferred stocks for a variety of reasons.  The three reasons below are the most common.

  1. Preferred stock issuances give companies a relatively cheap way to acquire additional capital.  The preferred market is dominated by banks and related financial institutions, which are required by regulators to have adequate Tier 1 capital to support their liabilities.  Tier 1 capital includes common equity, preferred equity and retained earnings.  (Note that as per the recently passed Dodd-Frank Act, cumulative preferred and trust preferred securities will eventually be phased out of their Tier 1 capital status.[1])  Since issuing preferred shares is normally cheaper than issuing common shares and avoids common ownership dilution, banks issue preferred shares to meet the required capital ratio set by regulators.
  2. Preferred shares can be used in balance sheet management.  Investors often prefer low debt-to-equity ratios, and issuing preferreds can better help to lower the debt-to-equity ratio than issuing debt.  A company in need of additional financing may also be required to issue preferred shares instead of debt to avoid a technical default, which could trigger an immediate call on previously issued bonds or an increase in interest rates on those bonds.  A technical default may occur when the debt-to-equity ratio breaches a limit set in a currently issued bond covenant.
  3. Preferreds give companies flexibility in making dividend payments.  If a company is running into cash issues, it can suspend preferred dividend payments without risk of default.  Depending on whether the preferred share class is cumulative or non-cumulative, a company may have to pay previously skipped dividend payments before restarting dividend payments in the future.

[1] Source: United States. Office of the Comptroller of the Currency, Treasury; and the Board of Governors of the Federal Reserve System. 2013.  “Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Capital Adequacy, Transition Provisions, Prompt Corrective Action, Standardized Approach for Risk-weighted Assets, Market Discipline and Disclosure Requirements, Advanced Approaches Risk-Based Capital Rule, and Market Risk Capital Rule”.

Contributors:
Phillip Brzenk, CFA
Associate Director, Index Research & Design

Aye Soe, CFA
Director, Index Research & Design

For more on preferreds, read our recent paper, “Digging Deeper Into the U.S. Preferred Market.”

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Core / Satellite Investment Strategies: Don’t Forget The Beta!

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Larry Whistler, CFA

President and Chief Investment Officer

Nottingham Advisors, Inc.

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Traditional Core/Satellite investment strategies typically combine a diversified asset allocation framework with a smaller alpha-seeking segment of the portfolio.  With an increased emphasis being placed by many investment advisors on so-called “tactical” managers, as well as other “alpha-generating” trades, it’s not surprising, though somewhat disappointing, that simple beta often gets ignored.  In a year when the S&P 500 gains over 25%, the S&P 400 nearly 28% and the S&P 600 surges 33%, S&P’s SPIVA scorecard can be a useful reminder as to the perils of chasing expensive alpha with too much of a portfolio’s assets.

By maintaining a solid investment core of diversified low-cost index funds, investors can be more selective in terms of paying up for riskier alpha-oriented exposures without wholly sacrificing the market return.  Besides the cost-effectiveness of index-based beta exposure, a core and satellite strategy can help investors avoid costly market-timing mistakes.  Absent some change in investor condition, core holdings remain fully invested throughout market triumph and market turmoil.  On the other hand, tactical or alpha-oriented trades may be implemented or unwound as circumstances dictate.  The buy-and-hold element of the core strategy reduces the probability of getting whipsawed during periods of rising volatility when investor sentiment tends to dominate rational thought.

Consistent alpha is very hard to come by, can be quite expensive and often requires investors to take on exposures at exactly the time their brains are telling them to get out of the market.  Frequently, alpha trades demand investors remain steadfast through periods of high uncertainty or extreme market volatility in order to realize outperformance versus the broader market.  Unlike the beta trade, however, investors should feel free to convert the alpha to cash when the underlying investment thesis changes or the client’s risk tolerance becomes maxed-out.

The main driver of portfolio return in Core / Satellite investment strategies tends to be the beta allocation.  It’s also typically the cheapest when index-based ETF’s or mutual funds are employed.  Academic studies and other market data continually point out the high cost and inconsistency of returns over time from alpha-oriented tactical strategies.  Used correctly, and this typically involves a high degree of due diligence, the satellite trades can either reduce volatility or enhance portfolio return.  If the core is misaligned, however, it may all be for naught.

To hear more on this topic, register for the upcoming S&P Dow Jones Indices webinar on Thursday November 14th.

 
S&P Dow Jones Indices is an independent third party provider of investable indices.  We do not sponsor, endorse, sell or promote any investment fund or other vehicle that is offered by third parties. The views and opinions of any third party contributor are his/her own and may not necessarily represent the views or opinions of S&P Dow Jones Indices or any of its affiliates.

The posts on this blog are opinions, not advice. Please read our Disclaimers.