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Hope Over Experience

Harvesting the Size Factor Premium

PMIs vs. Pan Asia Bond Markets

The Rieger Report: Munis Face an Unholy Trio

European Government Bond Markets Continue Sell-Off With the Exception of Sweden & Norway

Hope Over Experience

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Craig Lazzara

Managing Director and Global Head of Index Investment Strategy

S&P Dow Jones Indices

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Second marriages, Dr. Johnson reminds us, sometimes represent the triumph of hope over experience. The same applies to many arguments for active investment management.

Last week, e.g., The Wall Street Journal announced, with a note of triumph, that “So far this year, actively managed U.S. stock mutual funds have outperformed funds trying to clone the market’s overall performance.”  As of April 30, the Journal reported, the average active fund was up by 2.25%, against the 1.92% return of the S&P 500.  Leaving aside methodological issues like how the 2.25% is computed (simple average or asset-weighted average?) and the statistical significance of a 33 basis point difference, there’s a more important difficulty with this comparison.

Despite my personal affection for the S&P 500, it is not the appropriate benchmark for all U.S. equity portfolios, let alone for an arbitrary average of mutual funds.  In the four months ended April 30, e.g., the S&P 400 MidCap Index rose by 3.74%, and the S&P 500 Growth Index was up 2.96%.  So if the Journal’s average fund tilted toward midcap or growth stocks, it would automatically gain an advantage in this period.  In fact, almost the entirety of the 33 basis point gap might be due to the tendency of equal-weighted indices to outperform their cap-weighted counterparts.  (In the first four months of 2014, the S&P 500 Equal Weight Index was up by 2.21%.)

The proper way to benchmark active managers is one by one.  For some strategies, the cap-weighted S&P 500 will be perfectly appropriate; for others, different benchmarks will provide the asset owner with more insight.  The point of benchmarking, after all, is to understand to what degree a manager’s results come from factor tilts which can readily be indicized.   If fund owners do not calculate their manager’s outperformance, or “alpha,” against the correct benchmark, they are at great risk of paying active fees for performance that could have been obtained passively.

And here, of course, lies the problem for all active investors: there is no natural source of alpha.  If I’m to be above average, someone else must be below average, and the weighted sum of the winners’ outperformance must be exactly equal (before costs) to the weighted sum of the losers’ underperformance.   Passive investors avoid becoming the source of someone else’s alpha.  It’s a strategy firmly founded on experience, rather than hope.

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

Harvesting the Size Factor Premium

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Justin Sibears

Managing Director, Portfolio Manager

Newfound Research

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Factor investing is a well-documented method of generating excess returns, but some of the practical aspects of it are often overlooked in academic research, which tends to focus on “pure” premiums. Investors wanting to access these factors – size, value, volatility, momentum, etc. – are presented with a number of investment alternatives that aim to harvest the factor premium in different ways, and deciding which to utilize can be difficult.

For the size premium, one obvious choice is an ETF tracking the S&P SmallCap 600 index. However, other options may look surprisingly similar. The chart below shows the S&P SmallCap 600 index along with the S&P 500 index and the S&P 500 Equal Weight index.

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Performance statistics of the three indices over the period from January 1995 to February 2015 are shown below.

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From this we can see that the equal weight version of the S&P 500 behaved a lot like the S&P SmallCap 600 with slightly better risk-adjusted returns.

If we look at the alpha of these two indices over rolling two year periods, we see that they exhibit very similar trends. The average alpha for the S&P SmallCap 600 index was 2.5% compared to 2.4% for the S&P 500 Equal Weight index, but the S&P SmallCap 600 index’s alpha was over 50% more volatile.

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While this analysis does not guarantee that these out/under-performance trends have been directly attributable to the “size” factor in both indices, it does hint that there is at least some overlap in risk factors underpinning the two.

One important consideration when dealing with factors is how they will be used within a strategy. Within our U.S. Factor Defensive Equity strategy, we consider five factors: momentum, value, dividend growth, low volatility and size. These are weighted in proportion to their inverse volatilities. Therefore, we care more about the risk-adjusted return of the factor rather than simply the factor premium. Because the risk-adjusted return of the S&P SmallCap 600 index is right in line with the S&P 500 index, accessing size in this manner would not have benefited the strategy; there was not really any risk-premium.

This is just a specific example of a well-documented phenomenon.

The size premium is arguably one of the weakest of the factor premiums, especially in recent history. In their paper “Quality Minus Junk”, Assness, Frazzini, and Pedersen of AQR examined different market cap stocks sorted based on their quality and found that the size premium is most pronounced in high quality stocks. Many small-cap indices are skewed toward lower quality stocks, and while the S&P SmallCap 600 index screens companies for profitability, we would expect a higher proportion of large-cap stocks to be classified as “quality stocks”, in general.

We chose the S&P 500 Equal Weight index ETF as our size factor not because it is the purest exposure to the size premium, but because its methodology complements our other factor exposures. If we had chosen the S&P SmallCap 600 or any other of a number of market-cap weighted small-cap indices, we would likely have less exposure to the beneficial quality factor.  Equally weighting the index also pairs with our value factor by avoiding many of the glamour stocks, and rebalancing back to equal weight captures benefits of mean reversion.

Ultimately, having a pure factor exposure may be ideal in an academic setting with a 70+ year investment horizon, but on the practical level where we operate, the best outcome is likely realized by utilizing more robust indices and combining them in an intelligent way.

————————————————————————————————————————————————————–The views and opinions of any contributor not an employee of S&P Dow Jones Indices are his/her own and do not necessarily represent the views or opinions of S&P Dow Jones Indices or any of its affiliates.  Information from third party contributors is presented as provided and has not been edited.  S&P Dow Jones Indices LLC and its affiliates make no representations or warranties of any kind, express or implied, regarding the completeness, accuracy, reliability, suitability or availability of such information, including any products and services described herein, for any purpose. 

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

PMIs vs. Pan Asia Bond Markets

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Michele Leung

Director, Fixed Income Indices

S&P Dow Jones Indices

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The China PMI continued to show deterioration while the headline PMIs for other countries like South Korea, Taiwan and Indonesia also ticked down.  The market is expecting more easing to come in order to support the growth.

As of May 15, 2015, the S&P Pan Asia Bond Index rose 0.10% this month, bringing the year-to-date (YTD) total return to 2.40%, yet the individual market showed mixed performance. The S&P Indonesia Bond Index continued the slide and fell another 0.79% in May. Please see exhibit 1 for YTD and 1-Year total return performance.

On the other hand, China is the best performer of the month. The S&P China Bond Index rose 0.70% MTD and 2.85% YTD, led by the gains in the corporate bonds. On the back of the strong Chinese equities rally, the S&P China Convertible Bond Index jumped 11.4% YTD. The Chinese offshore RMB bond market, represented by the S&P/DB ORBIT Index also went up 1.94% YTD. Though the index’s yield tightened by 33bps to 4.37%, it offers yield pick-up over the onshore bond market.

Exhibit 1: Total Return Performance of the S&P Pan Asia Bond Index

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

The Rieger Report: Munis Face an Unholy Trio

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J.R. Rieger

Head of Fixed Income Indices

S&P Dow Jones Indices

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Three storms are converging on the municipal bond market: supply, interest rates and bad news headlines – a powerful trio of bad news for the municipal bond market.

  • The S&P Municipal Bond Illinois Index is down 1.55% for month-to-date and is the worst performing state index for the month so far.  The index is down 1.16% year-to-date.
  • The S&P Municipal Bond Illinois General Obligation Index is down 2.63% month-to-date and is the worst performing G.O. index.  The index is down 3.06% year-to-date.  Chicago General Obligation bonds make up 35% of this index by market value.
  • The S&P Municipal Bond New Jersey Index is down 1.07% month-to-date and is the second worst performing state index for the month.  The index is down 1.1% year-to-date.
  • Puerto Rico is having a dead cat bounce in May as the S&P Municipal Bond Puerto Rico General Obligation Index is up 2.37% month-to-date.  The index remains in the red for the year so far down 0.97% year-to-date.

The combination has put a heavy weight on the investment grade tax-free bond market which has seen negative returns in 2015.  The S&P National AMT-Free Municipal Bond Index is down 0.73% month-to-date and 0.36% year-to-date.

One bright light is the municipal high yield bond market as the S&P Municipal Bond High Yield Index is up 0.82% year-to-date helped by positive performance in May by Puerto Rico bonds and a recovery over 3.2% of the Tobacco Settlement bond sector.

 Muni Yields & Returns 5 19 2015

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

European Government Bond Markets Continue Sell-Off With the Exception of Sweden & Norway

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Heather Mcardle

Director, Fixed Income Indices

S&P Dow Jones Indices

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Most European government bond markets continued their downward spiral during the week of May11th, 2015, led by a sell-off in US Treasury markets.  New supply from the US Treasury pushed yields up (bond prices down) and aided a global downward trend.  Europe is showing its sensitivity to uncertainty over when the fed will start to raise rates.  This coupled with concerns that European bond markets are overvalued in light of the ECB’s QE expectations, and whether deflation concerns are over-hyped, are giving the market mixed signals.

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European government bond markets are moving in tandem for the most part, despite conflicting inflation numbers.  While inflation is picking up in Germany and France, with consumer prices rising in both countries for the month of April YOY, Italy and Spain are seeing lower prices.   Italian CPI was down at -.1% for the month of April YOY, while Spain’s CPI is at -.7% in April YOY.  All four of these markets sold off causing yields to spike 10bps and up since Friday’s close.

Norway and Sweden did not sell off and actually rallied on Wednesday.  Swedish consumer prices declined .2%, causing concerns that Sweden will need to lower rates further.  From Friday’s close, the S&P Sweden Sovereign Bond Index yield tightened 2bps to close at .30% as of Wednesday.  Norway’s CPI for April clocked in at 2% YOY, and its bond market rallied as well.  The S&P Norway Sovereign Bond Index, initially sold off on Tuesday only to bounce back again along with Sweden.   The S&P Norway Sovereign Bond Index tightened 1bps to 1.31% for the same timeframe.

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