Indexology^® Blog

Aficionados of our SPIVA reports will recognize that most active managers underperform passive benchmarks most of the time.   For example, between 2000 and 2014,  a majority of large-cap U.S. managers beat the S&P 500 in only three calendar years.  The records of mid-cap managers against the S&P MidCap 400 and small-cap managers against the S&P SmallCap 600 are equally undistinguished.

Since they’re relatively uncommon, years when the majority of managers do outperform naturally attract our attention.  For example, in 2013, two-thirds of all Canadian equity managers beat the S&P/TSX Composite, a dramatic improvement from results in 2012 and prior years.  What was special about 2013?  Perhaps it was that the S&P/TSX Composite was up 13%, while the S&P 500 rose by better than 32%.   Given the difference in Canadian and U.S. returns, a Canadian manager who made a tactical foray south of the border in 2013 might have been very well rewarded for doing so.  (In 2014, when Canadian and U.S. returns were much closer, only 26% of Canadian managers outperformed.)

Similarly, for four consecutive years between 2007-2010, the majority of U.S. large-cap value managers outperformed the S&P 500 Value Index.  Of course, those years straddled the global financial crisis, during which time the S&P 500 Value Index declined by a cumulative -13.5%.  Meanwhile, the S&P 500 Growth Index rose by a cumulative 7.5%.  Perhaps value managers as a group were aided by an ability to tilt toward higher-growth issues.

What these examples illustrate is that there are at least two ways to skin the active management cat.  We can call them, broadly, selection and allocation, and we’ve been looking at examples of successful allocation calls — from Canada into the U.S., e.g., or from value into growth.  Selection, on the other hand, denotes the process of overweighting and underweighting issues within a manager’s benchmark index.  Managers can add (or lose) value by both selection and allocation, but the likely magnitude of their success is conditioned by different things:

• Stock selection is most valuable in periods of high dispersion.  Dispersion is a formal measure of the degree to which the best performers in an index are outperforming the worst.  The higher a market’s dispersion, the higher the value of a manager’s stock selection skill.
• Allocation strategies — be they among countries or within segments of a single equity market — likewise are potentially most profitable when the dispersion among component returns is high.

What does this tell us about 2015’s likely results for active U.S. equity managers?

• Selection strategies face significant headwinds.  Although U.S. dispersion will probably finish 2015 slightly ahead of 2014’s record low, it remains well below its long-term historical average.
• In 2015, the selection odds are against you.  In most years, the S&P 500 Equal Weight Index, which tells us the return of the average stock, outperforms the S&P 500.  When this happens, the implication is that most randomly-chosen portfolios would outperform the (cap-weighted) market average.  But through December 9, 2015, equal weight is lagging cap weight — the S&P 500’s total return is 1.44%, versus -2.23% for the S&P 500 Equal Weight.  The concentration of performance in larger-cap names exacerbates the challenges posed by low dispersion.
• Allocation strategies along the capitalization scale won’t help.  In some years there are substantial differences in performance between, say, the S&P 500 and the S&P MidCap 400.  In such times, managers benchmarked against the worse performer can benefit by tilting in the direction of the better performer.  Through December 9, total returns were 1.44% for the S&P 500, -1.65% for the S&P MidCap 400, and -1.24% for the S&P SmallCap 600.  So large-cap managers can’t hide by moving down the cap scale.
• On a more cheerful note, value managers have a better chance of outperforming than do growth managers.  Through December 9, the S&P 500 Value Index had declined -3.53%, while the S&P 500 Growth Index had risen 6.04%.  A value manager who makes an allocation toward growth may well benefit; not so the growth manager who goes in the opposite direction.

In 2014, 86% of large-cap managers lagged the S&P 500.  2015’s results may be somewhat better, but conditions for active managers should continue to be difficult.

Most Major Islamic Indices Outperformed Conventional Benchmarks in 2015
Most S&P Dow Jones Shariah-compliant benchmarks outperformed their conventional counterparts through November 2015, as the financial sector—which is underrepresented in Islamic indices—has underperformed, and information technology and health care—which tend to be overweight in Islamic Indices—have been top performers.

The S&P Global BMI Shariah and Dow Jones Islamic Market World Indices have been nearly flat year-to-date (YTD) as of Nov. 30, 2015, outperforming their conventional counterparts by about 2% each in U.S. dollar terms.  Over the same period, the S&P 500 Shariah gained 2.1%, beating the 1.0% gain of the S&P 500.  Islamic indices covering the Asia-Pacific region, Europe, emerging markets, and Pan-Arab equities all outperformed their conventional counterparts as well.

Global Equity Markets Recovered in October Led by U.S. Equities
Following a major summer downturn, global equity markets recovered in October, led by the U.S., which stands as the only major global region in positive territory as of the end of November in U.S. dollar terms.  It is important to note that the strengthening U.S. dollar has weighed on unhedged, non-U.S. equity returns.  Asia-Pacific and European markets are well in positive territory in local currency terms, as the Dow Jones Asia/Pacific Index and Dow Jones Europe Index have gained about 5% and 8% YTD, respectively.  Despite some recent stability in emerging market equities and currencies, the Dow Jones Emerging Markets Index remains down double-digits YTD.

MENA Equities Underperform as Oil Weakness Continues to Weigh on Returns
In contrast to other regions, MENA equities have continued to weaken in the first two months of the fourth quarter, as oil prices have continued to decline.  The S&P Pan Arab Composite Shariah has fallen nearly 15% YTD in U.S. dollar terms, trailing all other regions by a substantial margin, despite not experiencing the adverse currency effects versus the U.S. dollar that have affected other regions.

While consumers may enjoy the additional purchasing power provided by a decline in energy prices, Energy sector investors would prefer that they had a little more pain at the pump.

The Energy sector of the S&P 500 is having a year to forget. The index is down 20% year to date on a total return basis (through 12/7/2015) and faces continued headwinds as oil prices remain stubbornly low. (The S&P GSCI Energy sector is down 37% year to date.) Due to its recent struggles, the market capitalization of the S&P 500 Energy sector is down over $350 billion since the end of 2014.

Poor performance in the Energy sector is having a material impact on the return of the S&P 500. Year to date, the S&P 500 is up 2.89%, while the S&P 500 ex Energy is up 4.95% (both on a total return basis).

Declines in the Energy sector have occurred across capitalization ranges. In fact, when compared to the performance of small-cap Energy, the S&P 500 Energy Sector performance seems almost muted.

There is little time left in 2015 for the sector to make a recovery. So far, all it has fueled is a race to the bottom.

In May 2014, the new deal Gazprom signed to supply 38 billion cubic meters (bcm), which is about the amount NY state uses annually, of natural gas to China each year for the next 30 years changed the world more than anyone may have anticipated. It’s not just because it took 10 years to negotiate or was estimated to be worth about $400 billion at the time, but it seems to be the catalyst that sparked the current global oil war. In the midst of economic slowdowns in Europe and Asia and new technologies catapulting the U.S. into a leading world oil producer, OPEC decided to stop supporting oil prices and maintain market share by increasing oil production.

This isn’t the first time Russia has been at the receiving end of Saudi Arabia’s aim to maintain market share. Beginning in 1985, Saudi increased production by five times to drop the oil price from $32 to $10 a barrel, contributing to the collapse of the U.S.S.R. However, different forces are currently at work that are hindering OPEC’s strategy. While Saudi Arabia may be in a better financial position than Russia from their ability to produce oil cheaply, secure credit and continue investment, Russia – and the U.S. – have not slowed down production so fast. Russia’s economy has been helped by the ruble’s decline that has offset the U.S. dollar strength, and the U.S. producers have proved more resilient than Saudi might have expected.

The industry is different now than in the past. Currently, the low oil price has forced consolidation where merged companies are improving efficiencies to bring down the cost of production. The race has changed from a race for land to a race for efficiency. New technology and operational responsiveness are reducing costs significantly for shale producers but they might still feel pain from low oil prices. The financing and investment may be more challenging going forward so that could slow production. There should be more clarity into how much production may retract after the producer hedges come due in the first quarter of 2016. The open interest in the futures market, one of the places producers hedge, may be a key factor to understanding where the oil market will stabilize.

 In the futures market, the price formation of oil is dependent on volatility as the market tries to stabilize.  Please see the chart below for the historical relationship between oil volatility and price:

As OPEC continues to flood the market with oil, from a purely physical supply point (and all else equal,) oil price should fall, adding to the volatility. The higher volatility may become too much for investors that are long (opposite the short-side of hedging producers,) forcing them to sell. As the long side collapses, the futures market insurance becomes more expensive for producers. This may disincentivize producers to produce and store, forming the beginning of market stabilization. In the past, oil bottoms have coincided with peak volatility and a bust in open interest. Based on today’s levels, open interest of around 300,000 may be the level where enough production is halted to stabilize the market. This means there may be further increased volatility until more money exits the futures market. OPEC’s decision to continue production may accelerate this exodus. When open interest finally collapses, then oil may find its bottom. If the oil index matches its 2008-9 drawdown, history has shown that prices may go as low as $28.

However, one indicator says oil may have reached the bottom or is very near. In historical oil bottoms, the energy equity risk premium, that measures the difference between the S&P 500 Energy Sector and the S&P 500 Energy Corporate Bond Index, has switched from a discount to a premium. This indicator switched in Oct. 2015 and held through Nov. When the stocks outperform the bonds, after a period of underperformance, it shows a switch in sentiment and has indicated the bottom of oil in the past.

After the last OPEC announcement, energy stocks took a big hit and the premium reversed into a discount again. This is bad news for the oil market, but what is worse is that China changed and may have more power than Saudi Arabia. Not only has China’s economic growth slowed, but they stockpiled oil on the cheap to fill their strategic petroleum reserves, so they might not need as much oil going forward. Moreover, after the stock market volatility and currency devaluation, oil got more expensive for China so they might not be the mega-consumer Saudi is racing to capture.  It’s a bad equation when oil supply is not slowing and demand growth is not accelerating. That said, it’s possible the demand estimates are wrong since they are notoriously hard to predict.

Floating Rate Instruments can make a lot of sense in a rising interest rate environment

In my May 19 blog, I mentioned two strategies that investors could consider in a rising interest rate environment. Given the recent direction of short-term interest rates, I believe the information bears repeating with updated numbers.

Interest rates have been on the march since mid-October, thanks largely to the possibility of a hike in interest rates by the Federal Reserve. In general, bonds are vulnerable to falling market prices as a result of higher rates, but there are income investments that can be used to take advantage of, rather than fall victim to, rising rates. They’re known as floating rate instruments.

What’s happening with interest rates?
The 10-year US Treasury yield rose 0.30% from Oct. 14 through Nov. 16, based largely on anticipation of the Federal Reserve’s next move.¹ Ever since the Fed drove the federal funds interest rate to near zero, the looming question has been, “Will next year finally be the year that the Fed raises rates?” In 2015, that question changed slightly but crucially to, “Will this year finally be the year that the Fed raises rates?” With possible liftoff this December, markets are more responsive (i.e., volatile) to every economic release—and investors are carefully parsing every statement from Fed Chair Janet Yellen.

Enter floating rate instruments
When rates rise, bond prices fall. The math behind this basic bond equation is premised upon a security’s fixed coupon payment. However, with a floating rate instrument, coupons are not fixed — they rise and fall based on an underlying benchmark, typically resetting every three months based on 90-day Libor. As a result, two things happen.

1. Income and cash flow can rise as interest rates are rising (and fall if rates are declining). This can help preserve investor purchasing power if higher rates are accompanying rising inflation expectations.
2. Prices for floating rate instruments tend to be more stable. Since cash flows are only “locked” until the coupon’s next reset date, price volatility as a result of interest rate changes can be a fraction of what is experienced with fixed rate investments.

Two floating rate ideas for today’s market

1. Senior loans –Senior loans, also known as bank loans, are generally structured with floating rate coupons based on a spread over 90-day Libor. As such, interest rate risk tends to be measured by the number of days until the next rate reset, rather than the more traditional measure of duration used for fixed rate investments. Investors who are looking for exposure to high yield bonds, but are concerned about rates might prefer senior loans — most senior loans are to issuers rated below investment grade, yet these instruments have very low interest rate exposure.

2. Floating rate or “fixed to float” preferred securities –Investors have flocked to preferred securities in pursuit of higher income, but may not be aware of the significant rate risk imbedded in fixed rate preferreds. But not all preferreds are built alike. Floating rate preferred securities (or “floaters”) have coupons that reset periodically, typically based on a spread over 90-day Libor. “Fixed to float” preferred securities carry a fixed coupon for a set period of time (typically between five and 10 years), then convert to a variable rate structure. Interest rate risk is measured based on the amount of time until the next rate reset. As such, floaters have very low rate exposure. Meanwhile, fixed-to-float preferreds should experience measurable but diminishing volatility as a result of rate fluctuations during the fixed rate period of their life cycles. Both floaters and fixed-to-floating-rate structures tend to offer lower rate risk than fixed preferreds:

Conclusion
The rate path remains far from clear, but recent upward pressure on yields may have investors looking to decrease their interest rate exposure. Floating rate structures offer investors the opportunity to participate in, rather than fall victim to, a rising rate environment.
1 Source: Bloomberg as of Nov. 23, 2015

Important information
The S&P/LSTA U.S. Leveraged Loan 100 Index is representative of the performance of the largest facilities in the leveraged loan market.
The BofA Merrill Lynch US High Yield Index tracks the performance of US dollar-denominated, below-investment-grade corporate debt publicly issued in the US domestic market.
The Barclays U.S. Aggregate Bond Index is an unmanaged index considered representative of the US investment-grade, fixed-rate bond market.
The Wells Fargo^® Hybrid and Preferred Securities Floating and Variable Rate Index is a market capitalization-weighted index designed to track the performance of preferred stock, as well as certain types of “hybrid securities” that are functionally equivalent to preferred stocks, that are issued by US-based or foreign issuers and that pay a floating or variable rate dividend or coupon.
The BofA Merrill Lynch Core Plus Fixed Rate Preferred Securities Index tracks the performance of fixed rate, US dollar-denominated preferred securities issued in the US domestic market. Securities must be rated at least B3 (based on an average of three leading ratings agencies: Moody’s, S&P and Fitch) and must have an investment-grade country risk profile (based on an average of Moody’s, S&P and Fitch foreign currency long-term sovereign debt ratings.
The BofA Merrill Lynch Adjustable Rate Preferred Securities Index tracks the performance of US dollar-denominated, investment-grade, floating rate preferred securities publicly issued in the US domestic market. Qualifying securities must have an investment-grade rating (based on an average of Moody’s, S&P and Fitch) and must have an investment-grade-rated country of risk (based on an average of Moody’s, S&P and Fitch foreign currency long term sovereign debt ratings).
Libor, or the London Interbank Offered Rate, is a benchmark rate that some of the world’s leading banks charge each other for short-term loans.
Interest rate spread is the difference between the average yield a financial institution receives from loans and the average rate it pays on deposits and borrowings.
Relative value refers to the value of one investment relative to another.
Floating rates are interest rates that are allowed to move up and down with the rest of the market or along with an index.
Duration is a measure of the sensitivity of the price of a fixed income investment to interest rate changes.
Effective duration is a measure of the sensitivity of the price of a fixed income investment to interest rate and bond cash flow changes.
Strip yield removes the accrued dividend from the yield calculation, offering a more accurate picture of the current yield (bond interest/coupon divided by the market price).
Yield-to-maturity is the rate of return anticipated on a bond if held until the end of its lifetime.
Diversification does not guarantee a profit or eliminate the risk of loss.
There is a risk that the value of the collateral required on investments in senior secured floating rate loans and debt securities may not be sufficient to cover the amount owed, may be found invalid, may be used to pay other outstanding obligations of the borrower or may be difficult to liquidate.
Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.
There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The fund’s return may not match the return of the underlying index. Please see the current prospectus for more information regarding the risk associated with an investment in the fund.
Most senior loans are made to corporations with below investment-grade credit ratings and are subject to significant credit, valuation and liquidity risk. The value of the collateral securing a loan may not be sufficient to cover the amount owed, may be found invalid or may be used to pay other outstanding obligations of the borrower under applicable law. There is also the risk that the collateral may be difficult to liquidate, or that a majority of the collateral may be illiquid.
Variable- and floating-rate securities may be subject to liquidity risk, there may be limitations on the fund’s ability to sell securities. Due to the features of these securities, there can be no guarantee they will pay a certain level of a dividend and such securities will pay lower levels of income in falling interest rate environment.