Indexology^® Blog

At S&P Dow Jones Indices, our research indicates that indexing small-cap and mid-cap stocks works as well as it does for large-cap stocks, even though the large-cap segment may be more efficient than its junior siblings. Nevertheless, the popular belief that indexing works better for large-caps is well-entrenched and widely endorsed by advisors, consultants, and other financial professionals.

A look at active fund performance through time, as excerpted from our July 2013 Persistence Scorecard, sheds light on why indexing works irrespective of market efficiency and is at least as effective for small-cap and mid-cap exposure as for large-cap. The figure below depicts performance results over two non-overlapping three-year periods for active funds that achieved first quartile status after the first period.

• While 23.2% of top quartile small-cap funds stayed in the first quartile after a second three-year period, almost a third (31.3%) fell to the fourth quartile.
• Over 1 in 10 (about 11.7%) first quartile small-cap funds were either merged with another fund, liquidated, or changed investment style (diverging from small-cap exposure).
• An equal proportion of first quartile mid-cap funds remained in the top quartile and fell to the bottom quartile (17.6%).
• Over 1 in 3 (about 33.8%) first quartile mid-cap funds were either merged with another fund, liquidated, or changed investment style. The large proportion (20.3%) diverging from mid-cap exposure seems to be unique to the mid-cap space. These managers may have more of a tendency to drift upwards or downwards in capitalization focus within their portfolios than large-cap or small-cap managers do.
• Active large-cap fund performance seems more uniformly distributed from period to period – with more equal proportions of top quartile funds subsequently finishing in second through fourth quartiles. This behavior could be related to market efficiency because higher information levels characteristic of large-cap stocks could drive less differentiation between active funds’ performance; i.e., they inherently may have less active risk.

Contrary to popular belief, the potential inverse relationship between market efficiency and active risk may be good reason to index small-cap and mid-cap stocks. Indexing has shown it can reliably deliver market returns and remain style consistent, whereas investing in active small-cap and mid-cap funds may result in overshooting markets during some periods, undershooting in others, altering style unpredictably, and generally compounding total risk without commensurate reward.

An article published Friday in Healthcare Payer News, “How health inflation could slow, or rise, in 2014” indicates a projected 6.5% increase in the large employer medical inflation for 2014 by PWC Health. As can be seen by the S&P Healthcare Claims Indices, an index series comprised of claims data provided by leading insurers in the US market, inflationary costs for large group medical claims fell from over 8% increase year over year in 2008 to about 4% from 2009 through the end of 2010, before dipping again to just under 3% in 2011 and 2012. For the ASO market, which comprises significantly more lives than Large Group, cost increases fell from 9% to roughly 5%, before dipping to just above 4% in 2011. An increase to 6% would represent a significant uptick in cost expenditures for the large employer market. The article goes on to talk about a growth rate of 4.5% after plan design changes, which take into account modifications to deductibles and other plan design features. The S&P indices, which were created in partnership and consultation with Aon Hewitt and Milliman consulting, are designed to look at overall costs of healthcare, and do not take into account plan design, which can be different from insurer to insurer. The same trends shown in the chart are also available from S&P for geographic regions, including census division, region, states, and major metropolitan areas.

The story plot thickens for Puerto Rico bonds as Moody’s placed bonds issued from Puerto Rico under review for a possible downgrade to below investment grade.  Selling pressure continues to mount impacting the market.  The S&P Municipal Bond Puerto Rico Index has seen a negative total return of 19.45% year to date and the weighted average price of bonds in the index has fallen by over 24% this year.   The weighted average yield (YTW) of bonds in the index ended at 7.26% or  419bps higher than investment grade bonds.

Investment grade municipal bonds tracked in the S&P National AMT-Free Municipal Bond Index have seen a negative 3.21% return year to date. Secondary trading in the muni market tends to get lighter before and after the holidays and it is still wrestling with a  heavy new issue calendar.

Tobacco settlement municipal bonds also have been weaker.  The S&P Municipal Bond Tobacco Index has declined by 8.96% year to date.  The index tracks over $82billion in par value of tobacco settlement bonds.  Yields on these bonds have risen 267bps over the course the year to end at 6.89%. These high yield, long duration bonds are impacted by both credit risk driven by declining tobacco use and the possibility of rising rates.

Volatility can feel like an earthquake.

As many investors can painfully testify, the chart below is typical of volatility.  A period of relative calm is disturbed first by a few small tremors, then by a precipitous rise.  At this point, risk breaks all connections with its normal level and climbs rapidly to a crystalized zenith of distress and chaos … before declining, at first rapidly then slowly; rollercoasting through a cascade of aftershocks as the grind back down to normality occurs.

Note: Chart courtesy of Groundswell Earthquake Outreach

Volatility can feel like an earthquake, and it’s far from simply a romantic metaphor.  As the reader may have already guessed, the chart above is not from any financial market. In fact it shows the measured magnitude of foreshocks, aftershocks and the actual ‘Great East Japan Earthquake’ at Tohoku on March 11^th, 2011. The reading of 7.1 immediately subsequent to the main spike is better known, resulting ultimately in the failure of the nuclear plant at Fukushima.

The statistical properties of earthquakes are the subject of much serious academic research, the fruits of which allow for empirical predictions of the number, magnitude and frequency of aftershocks.  In 2010 a group of physicists tested these sharpened tools on market volatility, with a remarkable degree of success.   Put simply, the statistical rules that explain earthquakes also fit and predict the patterns of stock market volatility.

Such analytic dissections are certainly interesting to options and volatility traders.   And these relationships provide the rest of us with a deeply meaningful analogy for the judicious management of risk.  If you live near a fault line, take very close heed of tremors; immediately after an earthquake, prepare for the aftershocks accordingly. 

On December 11^th, after the market closed, S&P Dow Jones Indices announced that Facebook will  join the S&P 500 as of the market open on Monday, December 23^rd.   This was probably one of most predicted, asked about and commented on additions to the S&P 500 in the last few years, Measured by the number of suggestions to (or demands of)  the index committee, Facebook ranks with other tech darlings including Google, Yahoo and AOL.

Facebook closed at $49.38 on December 11^th before the index announcement and opened at $51.04 on December 12^th, an overnight gain of 3.4%.  The move is similar to other recent index additions, but is a good deal lower than some of the overnight jumps seen in the past.  Most likely market participants were expecting an announcement on Facebook – one analyst predicted it shortly before the announcement of General Growth Properties as the replacement for Molex a couple of weeks ago.

Wall Street analysts and bankers ask about index additions because they are guessing who will be next. Their questions are Why this one? Why now? Did you worry about being under-weighted in that sector?  Some answers –

Why Facebook? The S&P 500 is often termed “leading companies in leading industries.”  Facebook is certainly a leading company in internet software and services which is definitely a leading industry. No one suggested that it should not have gone in. Why Now? Two factors: our guidelines require four quarters of positive earnings according to GAAP and Facebook only reached this last fall. Second, this is a large company and we wanted a date with a lot of trading and liquidity.  The third Friday of the last month of the quarter, when futures and options expire, is such a day.  Were we worried about sector weighting?  It was not the primary factor in this decision.  Who’s next? Stay tuned.