Indexology^® Blog

The market action in US stocks and Treasuries last week, especially on Wednesday, may be an experience that many investors would like to forget.  On Wednesday volume in US treasuries set a record as yields collapsed, stocks nose-dived and VIX topped 30 after opening the week at about 20.  As horrifying, or exciting, as it was, there may be lessons buried in the numbers.

Rarely does one specific event cause this kind of market turmoil; rather many sources of investor anxiety crowd together.  Among the protagonists were Ebola fears, slow European economies, weak US retail sales, and the Middle East.  Over-riding all of this was the growing conviction that the markets were surely in a correction, if not something worse, and no one would even guess where the bottom might be. As downward momentum gains strength it persuades investors that they should be getting out.  When that happens, investors want to sell the dogs — their least attractive unwanted and illiquid holdings.   But these are exactly the positions that are hardest sell if there is a market and impossible to unload if the market vanishes into the turmoil.

The response? Investors have no choice but to sell what they can sell, not what they want to sell.  What can they sell in the midst of the storm?  Anything in the deepest markets:  either US stocks or US Treasuries.  Last week the focus of fear was on equities and the answer was selling US stocks.  Hedging also may have been driving the market.  Equity investors who wanted a hedge for down side protection would have chosen the liquidity in S&P 500 futures.  Short futures positions can be read as a sign that stocks will fall further and may add to downward momentum.

While Wednesday’s action in US Treasury notes was more of a buying panic, the week’s events could be a hint of what might happen when the Fed finally does raise interest rates.   Some time, probably next year, the FOMC meeting notes will announce that monetary policy is being tightened and interest rates will rise.  Investors in a rush to sell unwanted bonds will find the only liquid market is 10 year Treasuries; they will be forced to keep junk bonds and sell, or short, treasuries. Others simply looking for a hedge will also short treasuries.  Those illiquid unwanted bonds will then be re-priced at lower levels consistent with the falling prices on over-sold US treasuries.   Fixed income prices could cascade downward.  It has happened before in the early 1990s when the Fed tightened more aggressively than expected and mortgage-backed bond traders got caught in a rush to the exit.

In late August, as reported by the Wall Street Journal, Walgreens announced the departure of their CFO at the end of the current year. This news came after a significant cut in forecasts by $1.1 billion from the original $8.5 billion forecast in fiscal 2016 pharmacy-unit earnings. According to the Wall Street Journal, “Walgreens hadn’t factored in, among other things, a spike in the price of some generic drugs that it sells as part of annual contracts.” This illustrates an opportunity where the S&P Healthcare Claims Indices may have been utilized as a tool to monitor the changing costs of both medical and drugs. As evident in the cost chart below, generic drug costs tend to be quite volatile, with overall costs growing at times in excess of 20%. However, looking at utilization, we can see that growth peaked in January of 2013, and has been declining ever since.

To gain insight on generic drugs, one may look at Unit Cost Indices, which show that while brand name drugs continue to escalate in price steadily over time, the cost of generic drugs on a Unit Cost basis tends to be more volatile, even declining in price at times. Because both the utilization and average cost of generic drugs are driven by factors such as the end of the patent protection period on brand drugs, high volatility is likely to be an inherent characteristic of generic drugs. By utilizing the S&P Healthcare Claims Indices, one may be able to better manage expectations for future changes in healthcare costs by studying recent trends.

Over the past two decades, real estate investment trusts (REITs) have emerged as a popular and efficient way for investors of all stripes to access the real estate asset class. Strong long-term total returns, combined with other key investment characteristics such as liquidity, high dividend yields, their potential to increase diversification and to hedge against inflation have contributed to the appeal of REITs.

Source: S&P Dow Jones Indices LLC; Barclays Capital. Data as of Sept. 30, 2014. Returns are based on total return index levels. REITs, Stocks, Bonds and Commodities are represented by the Dow Jones U.S. Select REIT Index, the S&P 500, Barclays Capital U.S. Aggregate Index and the S&P GSCI, respectively. Charts and tables are provided for illustrative purposes. Past performance is no guarantee of future results

REITs were established in the U.S. in the 1960’s and have evolved into a mature asset class here. However, outside of a handful of other early adopters such as Australia and Canada, the REIT structure had not been widely adopted globally until recently. In the past several years, REITs have gained traction globally as more and more countries around the world have enacted legislation authorizing REITs. In 2000, only 6 countries were eligible for SPDJ REIT indices. Today, twenty four are eligible with recent growth concentrated in Europe and Emerging Markets.

Source: S&P Dow Jones Indices LLC. Data as of Sept. 30, 2014. Charts and tables are provided for illustrative purposes.

Although the U.S. remains by far the world’s largest REIT market by value, it now represents only about half of the global opportunity set for listed real estate securities.

To learn more about the REIT structure, their evolution as an asset class, and their investment characteristics see our paper REITs: Making Property Accessible.

If the world were a simpler place, we would have one index per market. However, this is far from the case. Markets have multiple indices, and deciding which index provides the best exposure is no easy feat. This is especially true in developing markets like Colombia, where multiple indices are jockeying to be the “market benchmark.”

Looking back at the early days of indexing, the formula for the Dow Jones Industrial Average (DJI) was as simple as aggregating the prices of the largest stocks in the U.S. market and then dividing by the number of stocks. Times have changed. The level of complexity involved with index construction has increased, and thus, determining the choice of benchmark is a challenging task.

Currently, there are various indices representing the local Colombian market such as the COLCAP Index and the S&P Colombia Select. The COLCAP Index is managed by the local equity exchange and was relaunched with new methodology in 2013. The S&P Colombia Select Index is new on the scene and launched earlier this year.

Typically, a traditional market capitalization index with robust liquidity and market cap screens will usually suffice as a market benchmark. Using a GICS^® framework for comparison, only 6 of the 10 sectors are reflected in either Colombian index (see Exhibit 1). These indices do not include securities from sectors such as healthcare, consumer discretionary or telecommunications.

This creates potential sector and company risk due to concentration within the index. The S&P Colombia Select Index mitigates some of this risk by placing caps on the stock and sector concentrations. Stocks are limited to a 15% weight in the index, while sectors are capped at 40%. Energy is the sector with the biggest difference in weight between the two indices. The S&P Colombia Select Index has a significantly lower energy weight at 12.13% versus 18.51% for the COLCAP Index.

When constructing an index, there is a tradeoff between representativeness and investability. In markets such as Colombia, this is the single biggest determinant of risk exposure and liquidity of the constituents. The trick is to then construct an index that seeks to measure Colombian equities while also mitigating significant sector and liquidity risks. One of the unique aspects of the S&P Colombia Select Index is its innovative weighting technique, which considers trading volumes in order to improve the liquidity profile of the index. This helps support low-cost replication in a relatively illiquid market.

We are starting to see the evolution of index construction; index providers are recognizing that the key determinants of an index’s effectiveness are controlling risk and efficiently replicating index constituents.

A pure market cap weighting approach can be highly effective in many developed market indices. However in smaller markets, where concentration and liquidity risks are more common problems, it’s imperative that the index take these factors into account.

The above table has applied GICS sector classification to the COLCAP index for illustrative purposes only. The COLCAP index does not use the GICS system. The COLCAP index uses its own proprietary industry classifications for classifying securities. GICS is an industry classification scheme jointly developed and administered by S&P DJI and MSCI.

The SPIVA India Scorecard reports on the performance of actively managed Indian mutual funds versus that of their benchmarks, showing equal-weighted peer averages.  The mid-year 2014 scorecard, the latest SPIVA India report, has revealed that while active funds may be able to outperform their benchmarks in the short term, it becomes more likely for active funds to be outperformed by their benchmarks over the three- and five-year periods.

Some of the key findings from the report including the following.

1. The Indian stock market has remained bullish over the one-year period ending in June 2014. During this time horizon, the S&P BSE 100, the S&P BSE 200 and the S&P BSE MID CAP gained 35.37%, 36.43% and 59.93%, respectively.  Over the same one-year period, 34.18%, 22.22% and 44.93% of the active funds in the Indian equity large-cap, Indian ELSS and Indian equity mid-/small-cap categories underperformed their respective benchmarks.
2. Over the five-year period ending in June 2014, 54.36% of the active funds in the Indian equity large-cap category underperformed their benchmark, and close to 17% of the funds were merged or liquidated.
3. Over the same five-year period, active funds in the Indian equity mid-/small-cap category had a survivorship rate of only 77.33%, given the higher volatility of this market segment. In contrast, the active funds in the Indian ELSS category had a survivorship rate of 97.14%, which is not surprising given the fact that there is a lock-in period of three years for this group.
4. The S&P India Government Bond Index and the S&P India Bond Index gained 3.78% and 4.24%, respectively, over the one-year period ending in June 2014. Over the same one-year period, 59.62% and 29.82% of the active funds in the Indian government bond and the Indian composite bond categories underperformed their respective benchmarks.
5. The percentage of active funds in the Indian government bond category that underperformed the benchmark over the five-year period ending in June 2014 was 78.18%, which can partly be attributed to higher interest rates.
6. Over the same five-year period, the survivorship rate of the active funds in the Indian composite bond category was 92.86%, but the number of funds that underperformed the benchmark was 53.01%.

Let’s also look at shorter time periods ending in June 2014.

1. Most of the active funds in the Indian equity large-cap category and the Indian ELSS category were able to outperform their benchmarks over the one-, three- and six-month periods, and they outperformed the benchmark over the one-year period ending in June 2014, as well.
2. Active funds in the Indian mid-/small-cap category lagged the benchmark over the one- and three-month periods.
3. As interest rates remain high, most active funds in both the Indian government bond and Indian composite bond categories underperformed their benchmarks over the three- and six-month periods.
4. The survivorship rate was 100% only for the Indian ELSS and the Indian government bond funds over the six-month period.
5. The number of funds available to investors in the Indian composite bond category has increased by almost 7% over the six-month period ending in June 2014.