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Green Bonds, Green Projects, Green Indices and…a Greener World?

First, catch a rabbit

Risk Managing With ETF Portfolios

Alibaba, Hedge Funds and Transparency

What Ails Housing Starts

Green Bonds, Green Projects, Green Indices and…a Greener World?

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Julia Kochetygova

Head of Sustainability Indices

S&P Dow Jones Indices

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Green bonds are a recent market innovation that we first saw only a few years ago. In 2007, the European Investment Bank issued its first “green bond,” which was then followed by a similar bond from the World Bank. Together with the Oslo-based research center CICERO, The World Bank had identified a list of green topics. These topics included climate mitigation projects such as solar and wind installations, funding for new technologies that permit significant reductions in greenhouse gas (GHG) emissions and carbon reduction through reforestation and avoided deforestation. Also included were adaptation projects, such as protection against flooding, the implementation of stress-resistant agricultural systems and a few others.

Since then, the green bond market has grown rapidly at a compound annual growth rate (CAGR) of greater than 50%. With an estimated issuance exceeding USD 40 billion in 2014, compared with USD 11 billion in 2013 (and USD 5 billion in 2012), the market has expanded significantly in terms of scope, average issue size and issuer diversity. The green bond market is still relatively small, with about USD 45 billion currently outstanding versus USD 100 trillion for the global fixed income market. However, the green bond market has the potential to contribute substantially to the scale of trillions of dollars of private and public sector capital needed to combat climate change (see Exhibit 1). Many efforts are now being taken by various organizations to raise investor sensitivity to GHG-related effects.

Exhibit 1: The Road to a Low-Carbon Economy

The Road to a Low-Carbon Economy

Several questions arise in regard to this new asset class. First, how can we make sure that the green bonds are really delivering what they promise? Second, will additional pieces of the puzzle be required before we can see green bonds as a universe of its own? Third, if this group is to become a universe, what role can indexing play as part of the green investing ecosystem to attract capital at scale?

First, there are no mandatory or uniform criteria for green bonds. The green bond market, as it stands today, is “self-labeled” with voluntary issuer disclosure standards that vary in scope and quality. It is generally accepted that green bonds are required to direct their proceeds solely into projects that generate environmental, or more precisely, climate benefits. A voluntary set of guidelines (The Green Bond Principles [GBP][1]) developed by 13 industry participants in January 2014 assumes, among other things, that there is a robust project selection process according to the green criteria and that the use of proceeds is reported. Since the publication of the GBP, 49 institutions have signed up. Although the GBP only provide a voluntary framework, giving enough leeway to the issuer,compliance with them has become the cornerstone of the green bond independent verification process. This third-party verification itself forms part of the requirements, and it represents an important component of the assurance that the bond is green. Going forward, more rigorous standards can be expected to emerge.

Second, we believe that green-labeled bonds may not be all that is needed to define the green fixed income universe. There are quite a few bonds that have been issued without a green label but they have been designed to finance pure green projects, such as wind farms or solar installations. Such bonds, issued either as project finance instruments, project asset-backed securities (ABS) or corporate bonds of pure-play green companies, provide investors the opportunity to get a step closer to environmentally friendly or sustainable investing and to invest directly in projects that mitigate the impact of climate change without any reliance on a green label. We believe that the green fixed income universe would be incomplete without these bonds.

Third, why indexing becomes important for the green bond market. S&P Dow Jones Indices has launched the S&P Green Bond Index and the S&P Green Project Bond Index as separate, but integral parts of the market benchmark for the evolving green bond universe. Both indices apply a set of transparent criteria related to green assets being financed. At a specified green credit quality level, a green bond investor does not have the ability to question the capital efficiency of the associated environmental benefits (e.g., a wind farm in China versus a green REIT in the U.S.), therefore, it is important to have an opportunity to diversify across asset types and geographies. The S&P Green Bond Index aims to achieve transparency and simplicity and to aid in the commoditization of this asset class. The S&P Green Project Bond Index addresses long-term investor objectives such as liability matching, inflation protection and stable, uncorrelated, long-term yields. The two indices happen to have different credit profiles (see Exhibits 2 and 3) and correspond to the specific range of the risk/return continuum that may be a match for different investor strategies.

Exhibit 2: Credit Rating Distribution of the S&P Green Bond Index

Credit Rating Distribution of the S&P Green Bond Index

Exhibit 3: Credit Rating Distribution of the S&P Green Project Bond Index

Credit Rating Distribution of the S&P Green Project Bond Index

The combination of both of these indices may create the much-needed transparency regarding the expected and actual performance of the green assets or projects, which is important for attracting long-term, large-scale and climate sensitive capital for investments.

S&P Dow Jones Indices cordially invites you to a complimentary live webinar for investment professionals where industry experts will discuss the next steps to making green bonds a mainstream asset class. Register here.

[1]For more information, see Green Bond Principles.

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

First, catch a rabbit

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Craig Lazzara

Managing Director and Global Head of Index Investment Strategy

S&P Dow Jones Indices

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I was reminded recently of the (regrettably apocryphal) recipe for rabbit stew which began with the words “First, catch a rabbit.”  The reminder came from an article by a leading active management shop, which argued that “the more assets that flow to passive strategies, the more potential alpha there could be for successful active managers.,,, Good active managers will be able to benefit from the migration to passive.”  Supposedly, the silver lining in the growth of passive management is that there will be less competition for active returns, and fatter rewards for investors who keep the active management faith.

At a certain level, the argument is tautological.  It’s the “successful” and “good” active managers who will supposedly benefit from the growth of passive management.  How will we know who they are?  By observing, after the fact, which managers outperform their passive benchmarks.  But outperformers are always considered “successful” after the fact, regardless of how much or how little competition there is from index funds.  Can we identify successful (i.e. outperforming) active managers before the fact?

Doing so requires us to assume that active skill is both present (i.e., that the thing we’re looking for really exists) and persistent (so that historical performance will help us find it).  In fact, neither of these things is true.  Our SPIVA reports, among others, have long demonstrated that most active managers fail to beat their benchmarks most of the time.  And above-average managers in one year have only a random chance of being above average the next year.

But let’s assume, for the sake of argument, that active skill is both present and persistent.  If that were true, which active managers would lose assets to index funds?  Logically, the growth in passive management should come at the expense of the worst active managers.  This matters, because active management is a zero-sum game.  I can only be above average if someone else is below average, and the aggregate amount by which all the winners win must be exactly equal (before costs) to the aggregate amount by which the losers lose.  So when the worst active managers lose business, the aggregate amount of underperformance falls.  Therefore the aggregate outperformance available to the best active managers also falls.

By reducing the assets run by underperforming active managers, indexing reduces the rewards for those who remain.  It’s harder than ever to catch that elusive rabbit.

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

Risk Managing With ETF Portfolios

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Rick Vollaro

Chief Investment Officer

Pinnacle Advisory Group

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Investment managers are always looking for ways to control risk in their portfolios, as good risk management is paramount for long term accumulation of wealth, particularly in uncertain market environments! Portfolio risk protection can be employed utilizing many different methods, each of which can be unique to a particular manager’s style and core competencies.

Structural and tactical risk management are key components to consider when constructing dynamic portfolios. Structural risk protection comes in the form of running portfolios that are diversified by and within asset class in addition to purchasing diversified baskets of securities rather than individual issues.   But good diversification is only one layer of protection and as investors have learned, it can have an inherent weakness in bear markets where correlation between asset classes can go to one at light speed. Therefore, our firm believes it is important to add a layer of tactical risk management to the structural composition of a portfolio.

One very effective tactical method to control risk is to have the freedom and flexibility to alter the broad asset allocation of the portfolios between stocks, bonds, cash, alternatives, etc.  Having the ability to dial up or down the amount of stocks or bonds in a portfolio can clearly make a material difference, and can be employed efficiently with today’s impressive selection of exchange traded funds (ETFs).

Another tactical tool that allows investors to risk manage without having to make allocation bets is to employ sector rotation. Given the explosion of high-quality ETFs in the marketplace, sector-rotation strategies can be implemented to alter US equity sectors, country exposure, fixed income sector and rate sensitivities, and commodity and currency exposures.   While sector rotation won’t take an investor out of the market, simply altering what is owned can be a material factor in returns during risky markets.

As an example, those investors that were simply willing to alter their US equity allocations and purchase defensive US sectors in their portfolios suffered less downside volatility materially than the broad market during the last two bear markets. During the last two market downturns, an investor that invested in an equal weighted composite of non-cyclical sectors (staples, healthcare, utilities, and telecom) lost an average of 13% less than S&P 500® index, and the best performing defensive sector averaged losses of roughly 20% less than the overall market.

If you are an advisor or small investor that is interested in learning more about how to use ETF portfolios to mitigate risk, join us at the S&P Dow Jones Indices event: “Navigating Market Uncertainty” on October 8th in New York City.

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

Alibaba, Hedge Funds and Transparency

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David Blitzer

Managing Director and Chairman of the Index Committee

S&P Dow Jones Indices

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Alibaba appears to have seized the 2014 prize for the biggest IPO price jump – from $68 to $93 on the first trade – as well as driving more speculation about its possible membership in the S&P 500 than anything since Facebook.  Unlike Facebook, Alibaba is a Chinese company and is not eligible for membership in the S&P 500.  (It is likely to find its way into various S&P and Dow Jones Chinese stock indices at some point.)  In response to the questions about the S&P 500, S&P Dow Jones did issue a press release on September 12th to clarify while Alibaba is listed on the New York Stock Exchange, S&P Dow Jones considers Alibaba to be a Chinese company.

So how did the most talked about IPO of the year end up on the NYSE? Alibaba is incorporated in the Cayman Islands and trades on the NYSE as an ADR.  Behind this is an unusual corporate structure with a series of companies which result in the shareholders having very little say about the board of directors, the management or anything else about the company.  The vast majority of Alibaba’s business is in China so one might think that the logical place to list would have been Shanghai or Shenzhen – China’s two stock exchanges.  Listing in China would have meant the stock would be inaccessible for investors outside of China and might have limited the buying at the IPO.  Hong Kong would have been possible except that the Hong Kong Exchange has stricter rules about corporate governance than the NYSE; Hong Kong declined the listing. Alibaba is not the first tech company to take advantage of the less strict corporate governance at the NYSE or NASDAQ.  Both Google and Facebook have multiple classes of shares with a super-voting class that assures insiders keep control of the company.   While Google and Facebook offer more transparency than Alibaba, the management is firmly in control.

Transparency for investors did score a victory last week in another place. CALPERS, California’s public employees’ pension system, the largest pension system in the US, announced it would sell all its hedge fund positions over the next year. CALPERS noted that returns haven’t met expectations, that the fees are quite high and that there is no transparency — investors don’t know what is being done with their money- they can only hope for returns.  One wonders whether CALPERS, or other pension plan that eschew hedge funds, will consider buying Alibaba ADRs.

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

What Ails Housing Starts

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David Blitzer

Managing Director and Chairman of the Index Committee

S&P Dow Jones Indices

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August housing starts, reported today, were disappointing at 956,000 units, a drop of 14.4% from July and 8% from August last year. Only twice this year have monthly reports of housing starts topped a million units at annual rates – from 1991 to the financial crisis in 2008, starts were never below one million.  To a large extent building houses hasn’t recovered from the financial crisis. If one uses the average number of houses started from 1995 through 2004 as a pre-boom-bust normal measure, housing starts in August were 59% of the normal level.

The details suggest there is much more to the story. Single family homes started in August were 50% of the normal rate while multi-family homes (apartments) were at 94% of the normal pace. The chart shows that there was a change in the shares of single family homes and apartments.  The single family share (in blue) dropped beginning in 2007, rebounded briefly in 2009 when the government provided tax benefits to first time home buyers and then fell from 2010 on.

 

Source:Bureau of the Census
Source:Bureau of the Census

What happened to keep people in apartments?  Renters who decided not to become home buyers are a part of the story.  The New York Fed (click here) provides an analysis of why people are renting rather switching to being home-owners.  First time home buyers account for 30% to 50% of home sales. The principal answers, in the chart from the New York Fed, are not enough money, too much debt or credit isn’t good enough.  The damage of the financial crisis is still with us.  Mortgage rates and home prices are barely mentioned.  Moreover, both renters and home owners expect moderate increases the home prices, enough to stay a bit ahead of inflation. About 60% believe owning a home is a good or very good investment; another 29% are neutral on investment value; with little difference between renters and home owners.  The idea that the financial crisis relief should have focused more people in debt may make sense.

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