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ETFs and Hedge Funds: At What Price Performance?

April Peaks and Troughs in the S&P/Case-Shiller U.S. National Home Price Index

Selling Oil Won't Feed Iran

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

ETFs and Hedge Funds: At What Price Performance?

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Tim Edwards

Managing Director, Index Investment Strategy

S&P Dow Jones Indices

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With the final numbers for the second quarter of 2015 now available, the research firm ETFGI today brought some long-anticipated news: the size of the exchange traded funds market has finally exceeded that of its older, more well-to-do cousins.  It may have taken a little longer than we expected, but ETFs are now a bigger part of the market than hedge funds.

In order to explain why hedge funds might be losing out in the race for assets, we thought we would re-examine the challenge of replicating hedge fund performance.  When it comes to individual hedge funds, which are typically unconstrained by assets, leverage or geography, replication is a difficult objective.  When it comes to a broad hedge fund portfolio, replicating performance is easier than you might think.

To begin the replication process, our “hedge fund” is going to invest half its money in U.S. bonds, and the remainder in global equities.  (We’ll use the S&P U.S. Aggregate Bond index to represent the first portion and the S&P Global 1200 for the second.)  Assuming we also rebalanced on a monthly basis, here’s how our hedge fund would have performed over the past five years.  For purposes of comparison, we also show research firm HFR’s benchmark of hedge fund performance.  The HFR Fund-Weighted Composite Index includes funds which are no longer open to new investors, so it is a fair representation of what only the largest and best-connected asset owners may have available to choose from:

Graph 1

                    Sources: S&P Dow Jones Indices, HFR as of 30th June, 2015.

The pattern of returns seems similar, which is encouraging.  And our decision to allocate to equities and bonds in equal proportions means that the overall return from our replication strategy is much higher.  Well done us!

But congratulations are premature.  Our replication strategy does not include costs, or fees.  The replication costs of broad-based, passive indices are de minimis, but we should not undervalue our unique insights (we are replicating a hedge fund, after all).  A fee of 1.50% per annum seems reasonable, and we’ll take 15% of any profits (provided we’re at least breaking even over the past 12 months). Here’s how our performance looks now:

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                    Sources: S&P Dow Jones Indices, HFR as of 30th June, 2015.

That’s more like it; our replication strategy now performs very similarly to the average hedge fund.  And when it comes to the pattern of returns, are we replicating the hair-trigger market-timing and monthly swings of the masters of the universe? Yes, we are:

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                    Sources: S&P Dow Jones Indices, HFR as of 30th June, 2015.

One conclusion to draw is that perhaps there is a market for a product offering a 50/50 split of U.S. bonds and global large-cap equities, at a highly remunerative cost structure.  The other conclusion, perhaps shared by those whose continued flight to low-cost index funds are making the headlines today, is that the average hedge fund looks like a fixed blend of cheap investments, at high cost.

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

April Peaks and Troughs in the S&P/Case-Shiller U.S. National Home Price Index

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Marya Alsati

Product Manager, Commodities, Home Prices, and Real Assets

S&P Dow Jones Indices

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In this post, we are going to look at how April 2015 has fared compared with historical April months for the S&P/Case-Shiller U.S. National Home Price Index. Exhibit 1 depicts the historical monthly returns (April over March) of the S&P/Case-Shiller U.S. National Home Price Index, since 1987. All returns refer to April over March returns unless otherwise specified.

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The April 2015 gain of 1.06% was the smallest April-over-March gain since 2011 (0.99%), but it was the largest monthly gain in the recent 12-month period ending April2015.

It can be seen from Exhibit 1 that the trough was around the 2008-2009 period. There also appears to be two peaks in the index—one in 2005 and a post-trough peak in 2013. The period between 1987 and 2003 appears to show moderate gains and losses, while the period from 2004 to 2015 seems more turbulent.

Exhibit 2 summarizes the peak and trough periods for all 20 metro areas in the S&P/Case-Shiller Home Price Indices and the S&P/Case-Shiller U.S. National Home Price Index. The first peak period is defined between year 2000 and the trough period of the S&P/Case-Shiller U.S. National Home Price Index in 2008.

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Of the 20 metro areas, 12 peaked between 2003 and 2006. Atlanta, Chicago, Minneapolis, and San Francisco peaked as early as 2000, while Cleveland and Dallas do not appear to have had that first rally. Las Vegas had the biggest gain, at 5.4%, and Detroit had the smallest, with 0.9%. For the “second peak,” 15 of the 20 cities peaked in 2013, with Boston peaking as late as 2014, at 3.0%. The largest second peak was in April 2013 for San Fransisco , at 4.9%.

In terms of a trough, most of the cities had their largest April declines in 2008 and 2009. Chicago and Cleveland recorded their April troughs in 2007, while Boston and Dallas reported theirs in 2011. The largest April decline was in Miami in 2008, down 4.1%.

The S&P/Case-Shiller U.S. National Home Price Index (the “Index”) was launched on May 18, 2006. However, it should be noted that the historic calculations of an Economic Index may change from month to month based on revisions to the underlying economic data used in the calculation of the index. Complete index methodology details are available at www.spdji.com. It is not possible to invest directly in an index.

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

Selling Oil Won't Feed Iran

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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Now that negotiators have reached a deal aimed at reining in Iran’s nuclear program, Iran may get relief from some sanctions that may allow it to raise oil output. Though it could take time for supply to come onto the market, it depends on how long it takes for the International Atomic Energy Agency (IAEA) to verify all necessary nuclear-related actions have been met. Also, while oil in floating storage could come to market quickly (roughly 180 kb/d for 6 months according to IEA) and oil from already developed fields might be easier to deliver, underinvestment in production capacity and further negotiations of foreign investment from global oil companies may delay additional supply for significant time. It is extremely difficult to estimate future Iranian output not only from their own variables but based on how other suppliers will react to the news to maintain their market share ahead of Iran’s return.

The magnitude and direction of oil after Iranian supply comes to market is unknown. When less is known, volatility generally picks up as has happened in past oil crises. Also historically, open interest has had to crash before oil stabilized. Not only may OPEC’s last decision to continue production backfire from fund managers cutting their bets, but recent trade data from the Commodity Futures Trading Commission (CFTC) shows speculators have made their sharpest crude selloff in more than two and a half years. This is a critical point because the open interest is now at its lowest monthly peak in 2015. Also, the open interest has historically dropped about 1/3 before volatility normalized and now the numbers are showing the drop from roughly 500,000 to 300,000. This may be an inflection point indicating market rebalancing may be in its early stages.

Inflection Point Crude

Although the open interest may be collapsing now to initiate the start of the bottoming process, there is trouble for Iran. The timing is terrible because oil has continued to be supplied in excess (as shown below by the negative roll yields from contango) since July 2014. As they re-enter the market, it may cause more downward pressure on oil prices, limiting the upside on their revenue.

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

A consequence of Iran’s lower potential revenue is that it may hinder its ability to import healthy food to feed its population. Since its climate is not ideal for production, and is warming, Iran is food insecure and needs to rely heavily on imports. Iran imported $214 million worth of wheat in 2013 with other major imports including corn, soybeans and meat but malnutrition and obesity has risen as imports of cheaper sugar (DJCI Sugar lost 14.1% YTD as of July 13, 2015) have replaced many fruits and vegetables.

The concurrent glut of oil as Iran re-enters the market with the agricultural and livestock term structures that are now showing shortages can work against the budget both ways. This is particularly bad timing as contango (shown as negative) is now flipping towards backwardation (shown as positive) in these commodities – with the exception of soybeans:

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

Even worse for Iran is that importing food may be more expensive than ever due to the highly predicted El Niño. Agricultural prices have been increasing at an accelerated pace with each El Niño since 1982 by roughly 2.6% with large possible spikes following the heat waves.

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

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.