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The Impact of Currency Exposure: Evidence From the Performance of Actively Managed Global Equity and Bond Funds

Forget China: A Little Greece Goes A Long Way

An Index Provider’s Perspective on the Growing Australian ETF Market

Credit Default Spreads…Moving On Up

Commodity Indices Can Outsmart Another 45% Oil Drop

The Impact of Currency Exposure: Evidence From the Performance of Actively Managed Global Equity and Bond Funds

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Aye Soe

Managing Director, Global Head of Product Management

S&P Dow Jones Indices

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In the past 18 months, currency hedging has become one of the hottest topics in the investment community.  As the U.S. economy strengthens and decouples from the rest of the developed and emerging economies, and as there is unprecedented quantitative easing by the Bank of Japan and the European Central Bank, it is nearly inevitable that the U.S. dollar will rally strongly against other major currencies.  The movement into currency-hedged, passive investment products has been  strong, as investors seem to be looking at their non-USD exposure.

For a USD investor, currency hedging has long been part of fixed income portfolio management, as currency volatility plays a significant role in international bond returns.  However, it is not as prevalent in equity investing.[1]  That has been changing as the spreads between hedged international equity portfolios and unhedged international equity portfolios has widened considerably in recent months, and they may widen even more, all else being equal, if other major currencies continue to weaken relative to the U.S. dollar.[2]  For example, the S&P Global Ex US LargeMid BMI Index returned -3.02% in 2014, while its USD-hedged counterpart delivered 6.04% during the same period, representing over 900 bps in performance differential.

The impact of currency hedging has investment implications beyond just returns and volatility.  Those that are tasked with evaluating managers can observe that during periods in which the U.S. dollar is increasing, a manager’s decision to hedge or not to hedge the currency exposure could mean the difference between underperforming and outperforming, depending on the benchmark used.  This can be noted in the relative out/underperformance percentages of actively managed international equity funds and fixed income funds against their respective USD-hedged and unhedged benchmarks over the past 12 months ending Dec. 31, 2014 (see Exhibits 1 and 2).

In 2014, over 77% of actively managed U.S. funds invested in international equities underperformed their respective unhedged benchmarks.  The figure is worse when compared with the USD-hedged version, with 100% of the managers underperforming it.  Similarly, in the area of fixed income, only 36% of global income managers underperformed the unhedged benchmark.  However, when compared against the returns of a hedged benchmark, an overwhelming number (91%) underperformed.

The stark difference in performance between those managers, depending on the benchmark used, highlights the potential need for investors to consider currency management in the near to medium term when it comes to international investing.  While it can be argued that the currency hedging decision is one of active management that should be left to professional investors who can make those calls based on macroeconomic conditions, investors allocating capital to active managers may need to dig deeper and understand what type of returns they may be getting.  In addition, they must carefully consider what an appropriate benchmark should be for those international investment returns.  Comparing the returns of a hedged portfolio with those of an unhedged benchmark may not be an apples-to-apples comparison, as the active currency bets that the managers are taking are not captured in the unhedged benchmark returns.

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[1] To be fair, the decision to not hedge the currency exposure in international equities during the past decade had a lot to do with the weak U.S. dollar against major currencies.

[2] Over the long term, hedged and unhedged international equity portfolios have tended to perform similarly.

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

Forget China: A Little Greece Goes A Long Way

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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According to CNN Money, China’s stock market just lost about $3.25 trillion. That is the equivalent of more than the size of France’s entire stock market, about 60% of Japan’s market, and twice the size of India’s stock market. Despite the seemingly large size, the Chinese stock market still plays a surprisingly small role in China. According to The Economist, “the free-float value of Chinese markets—the amount available for trading—is just about a third of GDP, compared with more than 100% in developed economies. Less than 15% of household financial assets are invested in the stockmarket: which is why soaring shares did little to boost consumption and crashing prices will do little to hurt it. Many stocks were bought on debt, and the unwinding of these loans helps explain why the government has been unable to stop the rout. But this financing is not a systemic risk; it is just about 1.5% of total assets in the banking system.”

Additionally, according to the latest report by the International Energy Agency (IEA), robust growth has been seen across the Chinese (oil) product spectrum recently with higher-than-expected refinery activity. While the near 3% annual gain foreseen (IEA) for Chinese oil demand in 2015-16 is down from the double-digit percentage point gains seen only a few years back, demand is still 11.13 million barrels per day.

Source: Oil Market Report, International Energy Agency. July 2015
Source: Oil Market Report, International Energy Agency. July 2015

So, forget about China.

However, Greece is delivering a double whammy to oil. The dispute between Greece and European leaders is depressing the euro, and whenever the euro gets depressed, the U.S. dollar gets relatively stronger and commodity markets suffer. While not all commodities fall with a stronger dollar, the five commodities of the petroleum complex have the greatest inverse sensitivity, ranging from -0.62 to -0.67.

If Greece were to exit the euro, any replacement currency it adopts may be severely debased; bringing additional downside pressure to Greek oil product demand as products become more expensive from a stronger U.S. dollar. The IEA cites a recent study of crisis-hit exchange rate regime changes by JPMorgan that concluded that the average depreciation in the first year of trading is between 40% and 80% versus the US dollar. Argentina, for example, saw 70% wiped off the value of the peso in 2002 alongside contractions of 10.9% in GDP and 8.6% of oil product demand. According to the IEA, a similarly sized contraction in Greece in 2016 would remove a further 15 kb/d. That may not seem like much but if Greece’s economic woes spill over into other EU countries, it may curtail oil demand growth across the region, and Europe’s demand is projected by the IEA to be greater than China’s at 13.52 million barrels per day.

Not only is the Greek debt crisis strengthening the U.S. dollar, but the unemployment and frozen banking system is also weakening oil demand. The recent imposition of daily cash withdrawal limits and refusals of credit cards at petrol stations will likely limit access to oil products. In simple terms, if the Greeks can’t pay for gas, there is no demand.

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

An Index Provider’s Perspective on the Growing Australian ETF Market

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Shaun Wurzbach

Managing Director, Global Head of Financial Advisor Channel

S&P Dow Jones Indices

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The Exchange Traded Fund (ETF) landscape in Australia continues to grow and mature in assets under management (AUM) and in number of ETF products offered. As of June 2015, the Australian ETF Market was reported to be at A$18.1 Billion in AUM and 107 ETFs traded on the ASX. As an index provider with deep roots in the Australian market, S&P Dow Jones Indices takes interest in this, because Exchange Traded Funds which are index-trackers are the delivery vehicles of index effectiveness and index-based innovations.

Index Effectiveness*: One way to judge if an index is effective is to determine if it measures an asset class or a market in an investible manner. For years, S&P DJI has conducted analysis and published a research report named S&P Index vs Active, or SPIVA®. The purpose of the SPIVA report is to compare the field of actively managed mutual funds against an apples-to-apples index benchmark in size and style. We now calculate SPIVA for several markets, including Australia. Here are some of the latest results for Australia:

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With our index benchmarks demonstrating that they are hard for many actively managed mutual funds to beat (with the notable exception of Australian Small-Cap), we conclude that indices are effective in measuring markets and asset classes, which can be accessed by ETFs that track these indices.

Index-based Innovations: Indexing measures international markets and asset classes beyond Australia’s shores. One of the presenters at our recent 5th Annual ETF Masterclass in Sydney and Melbourne said that “Australians may be the champions of home bias.” Several International ETFs list in the Australian market, providing the means to mitigate the risks of that home bias. The largest of these by size are tracking the S&P 500® index, measuring Large-Cap U.S. companies. Indices and the ETFs tracking them in Australia have also advanced to cover asset classes beyond equities. The Australian ETF market now offers ten fixed income ETFs which are index-trackers. Two of those, issued by State Street Global Advisors, are tracking S&P DJI fixed interest indices. Real Assets such as Real Estate and Commodities are covered by indices and there are a number of these available now as ASX-listed ETFs. You might expect to see Australian ETFs in the future covering infrastructure equity and debt Indices or other real assets that were formerly only accessible to institutional investors in illiquid ways. In this manner, the growth and advance of the Australian ETF market will democratize access to financial solutions.

The latest index-based innovations may be found in what some are calling smart beta indices. From an indexing perspective, smart beta may be partially described as an index designed to deliver a particular factor (value, quality, momentum, etc.) or an index which alternatively weights an asset class or both those features at the same time. In the Australian ETF Market, these smart beta strategies may be managed fund ETFs.  A new ETF product provider to the Australian market, ANZ ETFS has announced the launch and listing of two new smart beta ETFs which are index-trackers: one of these ETFs tracks the S&P 500 High Dividend Low Volatility Index, the other tracks the S&P/ASX 300 Shareholder Yield Index.

We judge that indexing effectiveness and indexing innovation may be beneficial for financial markets. However, as the Australian ETF market grows in number of ETF offerings and the complexity of these ETF offerings, an increasing burden of due diligence is placed on Aussie planners, wealth managers, and institutional investors who seek to benefit from what ETFs may offer.   As the index provider for 39% of these ETFs by number and 65% by AUM (please see table below), we believe that we have a part to play in the education component of that due diligence.

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By education, I specifically mean that we are in the position to share with you how index construction and other index rules and characteristics matter to the ETF tracking them. To that end, we can also share index historical performance data and analysis on that performance as a further guide to those seeking a better understanding of ETFs. An example of this type of education is “Why Does the S&P 500 Matter to Australia.” Also, a current list of S&P Dow Jones Indices which have been licensed by ETF providers and listed on the ASX may be found on spdji.com.

*A general (or working) definition of Index effectiveness is an index benchmark constructed to have investible characteristics, consistency in style and size, index historical performance in SPIVA which typically outperforms the majority of actively managed mutual funds in the same asset class, and the persistence to typically be above average over 3 and 5 year measurement periods when plotted against actively managed funds.

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

Credit Default Spreads…Moving On Up

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Tyler Cling

Senior Manager, Fixed Income Indices

S&P Dow Jones Indices

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The S&P/ISDA U.S. 150 Credit Spread Index has seen spreads widen by 56.52% since July 2014. This means investors are demanding over 50% more on the notional cost of default insurance on the largest investment-grade corporate bonds tracked by the S&P 500®. CDS “insurers” from the S&P/ISDA CDS U.S. High Yield OTR Index saw spreads widen only 26.07% in the past 12 months, with the major discrepancy coming in 2015. The YTD change in spreads is roughly 10 times higher for investment-grade CDS spreads than high yield…however this only tells half the story.

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The cost of default insurance for the S&P/ISDA CDS U.S. High Yield OTR Index still costs more than 4.5 times as much as for the S&P/ISDA CDS U.S. Investment Grade OTR Index, as protection on a loan of USD 1 million would cost USD 32,400 and USD 7,200, respectively. The important takeaway is that tumbling investor sentiment is not reserved for the high-yield sector, and this may not bode well for the equity market. Examining the trend for each index since March 2015, spreads are moving only one way…up.

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

Commodity Indices Can Outsmart Another 45% Oil Drop

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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Many key factors are currently driving oil down and the bloodshed might not be over. As mentioned in a recent CNBC interview, from current levels, the S&P GSCI Crude Oil Total Return could drop another 45% before surpassing energy’s worst historical loss of 78.4% that happened in 2008-2009.

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

The headwinds of the strong dollar from the Greek crisis, the seasonal slowing of gasoline demand post July 4th, increase in rig counts despite high inventory levels, possible lifting of Iranian sanctions that could ramp up production, and slowing Chinese crude demand plus their crashing stock market are all bad news for oil.

It is not only bad news for oil but the weak Chinese economy and stock market is a huge influence for copper given China consumes about half of the world’s copper. Since early 2011, copper has been dying a slow death but the loss of 3.5% on July 6, 2015  was the biggest one day drop in six months, since January 14, 2015.  Also, the weaker dollar from the Greek crisis is impacting all economically sensitive commodities – and copper is known to be one of the most sensitive to growth. Like oil, copper has about 50% left to fall before hitting new index lows.

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

However, Dr. Copper is not always so smart. Historical correlations only run about 0.4 with the Chinese GDP growth and copper actually performs well in weak recessions. It is only in strong recessions where copper tanks. Maybe this is the signal for the start of more than just a weak recession.

According to Jim Cramer, these things need to happen for another global financial crisis: 1. The Greek deal needs to be delayed further, causing the euro to go lower and the dollar to get stronger, which ultimately hurts U.S. exports (and commodities – but not all); 2. China needs to collapse from the weight of its stock market and trillions in bad loans; and 3. The Fed needs  to continue discussing raising rates, even though employment isn’t as strong as most thought and industrial production is still not great.

The problem is the worst is potentially just around the corner, coming in Q4, according to commodity seasonality.  Despite all the headwinds, the summer generally helps many of the commodities used for travel, construction and even grilling, which kept commodities flat through Q2. Now that the peak driving season has passed, a major catalyst is out of gas, and mid-July is precisely when the worst drawdown in history that lasted from July 14, 2008 to February 18, 2009 started. During that period, the majority of days (16 of 23) with the biggest losses (>4.0%) were in Q4 of 2008.

An investor might be wondering now if it is even possible to hold a basket of commodities without getting slaughtered. Maybe an active manager could pick out the winners, but probably not, given the results from last year’s conference poll where sugar (-16.9%), copper (-12.2%) and nickel (-28.2%) were cited as the best picks for the year going forward. All of those are performing worse than the composite benchmark, the S&P GSCI, that is down 7.3% YTD.

Maybe the smart answer is to simply use an equally weighted index like the Dow Jones Commodity Index (DJCI) rather than the world-production weighted S&P GSCI. To answer that, it must be possible for agriculture and precious metals to overpower the economically sensitive energy and industrial metals. After all, agriculture and livestock have historically very low correlations to the dollar – that is to be expected given people need to eat and these commodities are much more sensitive to weather. Even better now, is the extreme weather from El Nino may be the biggest driving force for food commodities, and on average, the positive impact on agriculture has accelerated with every El Nino since 1982. In the midst of all the current turmoil, wheat and sugar were positive on July 6, 2015, and 5 of 8 commodities in the sector remain positive for the year. Unfortunately, the bad news is that the weighting alone is not powerful enough to carry a commodity basket. Year-to-date through July 8, 2015, the DJCI, S&P GSCI Light Energy, S&P GSCI Risk Weight and S&P GSCI Roll Weight Select have lost 6.4%, 7.1%, 6.3% and 7.7%, respectively.

Another set of indices called “modified roll” addresses contract selection to help commodity performance during down markets. Historically it has been shown there may be a premium for giving up liquidity at the front end of the curve for later dated contracts, but it depended on the time period. Unfortunately, during this time period rolling is not working, and that is because there has been backwardation in commodities this year that has only recently flipped to contango. Year-to-date through July 8, 2015, the S&P GSCI Dynamic Roll, S&P GSCI Enhanced CommodityS&P GSCI Multiple Contract and S&P GSCI 3 Month Forward have lost 8.7%, 7.0%, 7.5% and 8.2%, respectively.

Again, now is a difficult time for commodities that might get even harder.  Is it possible to get smart enough to hold a basket that does not require picking single winners? Unfortunately, no long-only index has proven smart enough to generate a positive return during the worst down days of the past 10 years. That includes all days that dropped more than 4.0% for a total of 35 days. Not even our smartest long-only index, Dow Jones – RAFI Commodity Index, that combines smart rolling and weighting has proven successful (it is down 7.6% YTD.)

However, there is a set of broad-basket commodity indices that is smart enough to generate positive returns in the worst of times. These indices are a subset of a long/short family called “strategic futures” and they are strategic for a reason. The broader strategic futures include financial futures as well as commodity futures, but only the subset using purely commodity futures is examined for this analysis. Three indices, namely, the S&P GSCI Dynamic Roll Alpha Light Energy, the S&P Dynamic Commodity Futures Index (S&P DCFI) and the S&P Systematic Global Macro Commodities Index can be considered smart enough to perform in the worst commodity periods.

In the worst drawdown of the S&P GSCI that lost 70.9% from July 2008 – Feb 2009, the S&P GSCI Dynamic Roll Alpha Light Energy and the S&P Dynamic Commodity Futures Index (S&P DCFI) gained 10.7% and 14.1%, respectively, but despite out-performance over the S&P GSCI the S&P Systematic Global Macro Commodities Index still lost, but only 3.4%.

Extending this analysis by examining the 10-year time period into the best 35 days and worst 35 days gives more insight into the time when protection is needed most.  On average, the worst 35 days classified by all days with a greater than 4.0% loss in the S&P GSCI, generated a return of -5.3%. The modifications of long only indices helped but not enough to get positive results. In spite of the worst historical time, the long/short strategic futures indices were smart enough to be positive with average daily returns of between 28 and 129 basis points with some significant daily returns up almost 8.0%. Source: S&P Dow Jones Indices. Ten years of daily data ending July 7, 2015.Source: S&P Dow Jones Indices. Ten years of daily data ending July 7, 2015.

On the flip side, when the S&P GSCI posted its 35 biggest daily gains, all more than 3.5%, the strategic futures were basically flat. This combination of protection on the downside with flat performance in commodity bull markets preserves capital. Over long periods of time, smart indices that roll and/or weight differently have also performed well with reduced losses rather than positive returns in down periods. However, for real risk management and the chance for positive returns during the worst of times, the strategic futures have done the job best with all of the independence, transparency, liquidity and cost efficiency indices provide.

 

 

 

 

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