Indexology^® Blog

With the release of the latest SPIVA® Cross-Country Comparison results, the debate between active and passive investment management has once again ignited.  Proponents of passive management point to the SPIVA data as evidence of the inability (in aggregate) of asset managers worldwide to beat relevant passive indices over meaningful periods of time.  Meanwhile, proponents of active management suggest weaknesses in the passive approach, including the potential for active management to protect “on the downside” relative to index-weighted portfolios.

There are real dollars riding on winning the active versus passive argument.  Every time the debate re-emerges, battlelines are drawn and positions are defended vigorously around one question: is it possible to outperform on a risk-adjusted basis (generate “alpha”) consistently over an extended period of time?

Alpha is the part of a security’s return that remains after accounting for all known embedded risk factors.  Why is it seen as the pinnacle of investing?  Because in a world where we are told there are “no free lunches,” alpha is just that; a return component above that required for bearing all known risks, and thus attributed to investment skill.

In a competitive market where everyone has access to the same information and acts on it with equal speed, alpha can indeed be a sign of skill.  It could just as easily be a product of luck.  Over short periods of time, investment skill is indistinguishable from luck.  The longer a fund manager consistently delivers alpha, the more probable it is that skill rather than luck explains the alpha.

The case for passive investing is often held to rest on the Efficient Market Hypothesis (EMH).  It suggests that in a market that is efficient, all relevant information is already incorporated into each security’s current price, and any new information will be incorporated too fast to consistently act on and profit from.

While some proponents of active management view EMH adherents as nay-sayers lost in the axioms of their own theoretical world, the disdain is not reciprocated.  EMH is a vindication of the competitive spirit of capital markets, not a criticism of it.  Alpha is hard to find precisely because there are so many highly intelligent and extremely motivated people looking for it.

In 1979, according to the Investment Company Institute, there were some 530 mutual funds in the U.S.  By 2013, this number had increased 14 fold to exceed 7,500 funds.  Asset management has been a favored destination for MBA graduates the world over for at least the past two decades.  They, along with CFA charter holders and those with doctorates in physics and applied mathematics, compete for entry into the lucrative world of asset management.

Yet, armed with all this prodigious human talent together with the fastest computational technology, alpha has become harder to consistently generate.  Why?

The answer may lie in the “paradox of skill,” a phenomenon that has been observed in competitive arenas such as professional sports.  The crux of this paradox is that as time passes and competition intensifies, the skill level of the average participant increases.  Importantly however, the spread of skill, from the most talented to the least, reduces with time.  In an environment where the absolute skill level is rising while the relative skill level is in decline, luck starts to play a larger role in outcomes.

Take baseball.  Why has no player in Major League Baseball had a batting average over .400 since Theodore “Ted” Williams of the Boston Red Sox hit .406 in the 1941 season, despite pros becoming far better conditioned over the intervening 70+ years?

In a similar fashion, the batting average of legendary Australian batsman Sir Donald Bradman of 99.94 runs (from 1928-29 to 1948) has never been matched in the modern era, where an average above 50 is rare.

Both Williams and Bradman were superb athletes of their day, yet it is unlikely that they would have been able to replicate their stats against the average opponent of the modern era.

The dawn of professional sport heralded a revolution in training, diet, physical and mental conditioning, and data analytics.  The result is an overall skill level in elite sports today incomparably higher than the past, yet without the most skilled players able to dominate as they could in previous eras.

A similar force is at work in professional investment management.  The average fund manager today is the financial equivalent of a professional athlete, with every advantage that a high IQ, elite education, and rigorous training can bestow, and yet despite all these attributes, the SPIVA results are unequivocal.  The ability to beat the market on a risk-adjusted basis consistently over time, especially after fees and taxes, isn’t getting any easier.

Blame it on the paradox of skill.

An alarming picture is being painted by an economically frail global economy: the threat of a U.S. Fed rate hike and renewed credit weakness driven by falling oil prices.  The S&P GSCI^® (TR) was down 30.8% YTD, with all sectors in the index reporting negative returns for the year, but the S&P 500^® and the U.S. stock market have not collapsed yet.  In fact, U.S. equities are on pace to outperform commodities for the eighth consecutive year, which would set a new record.  If this cycle changes, investors may need a way to protect themselves.

Historically, the CBOE Volatility Index^® (VIX), which many investors know as the “investor fear gauge,” tends to spike when markets are tumultuous.  VIX measures the expected 30-day volatility of the S&P 500.  When implied volatility is high, the intraday moves can be large, and when implied volatility is low, intraday ranges tend to be narrow.

Since 1990, the S&P 500 has dropped in 37% of months (115 out of 300) and on average, when it fell, it lost 3.5%.  When VIX gained, it gained an average of 16.4%.  In October 2008, the S&P 500 lost 16.9%, its worst month on record, while VIX gained 52.0% in the same period.

Exhibit 1 shows VIX and S&P 500 returns when equities are in negative territory.  It can be seen that in most cases where S&P 500 returns are negative, VIX returns are positive.

Since the current commodity crash has played a major role in slowing global growth, it is important to note that VIX could also protect against drops in commodity prices.  Since 1990, the S&P GSCI has fallen in 46% of months (142 out of 311).  In those months, on average, commodities fell 4.7% and VIX gained 3.4%.  Exhibit 2 shows VIX and S&P GSCI (TR) returns; when commodities are in negative territory, it can be seen that in most cases VIX returns are positive.

Volatility indices like the S&P/ASX 200 VIX, the S&P/JPX JGB VIX, and the S&P/TSX 60 VIX could offer similar protection globally.

Some high yield bond funds are reeling with the impact of the price of oil on energy related companies with debt.  The S&P 500 Energy Corporate Bond Index, tracking over $255billion in debt, is down over 6% year-to-date while the overall S&P 500 Bond Index remains in positive territory.  Energy bonds have been less volatile than the stock of these companies but a 6% drop is painful for bond investors.

More telling is how the credit markets are viewing the cost of buying default protection on the debt of energy related companies.  The cost of buying default protection has risen by 185% since May 1^st, 2015 indicating the credit markets are expecting more distress in the sector over the near term.  Based on the index the cost per $100,000 of protection on May 1, 2015 was $2,130 and the cost per $100,000 of protection on December 10^th was $6,080.

China’s onshore bond market recorded strong growth in the first 11 months of 2015 and its total return has increased 6.98% year-to-date (YTD), as measured by the S&P China Bond Index.  The S&P China Composite Select Bond Index, an investable index that tracks the performance of Chinese sovereign bonds, agency bonds and bonds issued by Central State-Owned Enterprises (CSOEs) rose 7.00%; the USD index that accounted for currency fluctuation gained 3.04% in the same period.

The one-year volatilities of Chinese bonds were 2.13% in CNY and 3.38% in USD.  The volatility of Chinese bonds is low when compared with the equity market; the volatility of Chinese equities over the past one- and three-year periods was more than tenfold that of Chinese bonds.  Chinese bonds have consistently outperformed Chinese equities, both in terms of total return and risk-adjusted return (see Exhibit 1).

Looking at the performance of the U.S., we have similar findings.  The volatility of U.S. equities over the past one- and three-year periods was approximately three times that of U.S. bonds, as tracked by the S&P 500^® Bond Index.  The S&P 500 Bond Index seeks to measure the performance of U.S. corporate bonds issued by constituents in the iconic S&P 500.  Though the total return of U.S. bonds may be lower, the risk-adjusted returns of U.S. bonds were comparable to those of U.S. equities over the past year (see Exhibit 2).

Based on this information, we can conclude two key observations in both U.S. and Chinese markets.

• These bond markets have substantially lower volatility than their respective equity markets.
• These bond markets have historically delivered comparable, if not better, risk-adjusted returns than their respective equity markets.

Think your gas prices are cheap? Think again.

The oil price drop since June 2014 has moved to become one of the most important factors in the global economy. Despite agreement on a chance to change policy, it has divided the world into winners and losers based on importers and exporters. Presumably the winners are the importers, but the countries that can highly benefit are the ones whose refiners pass through the price drop of the cheaper oil input down to the customers at the pump.

The U.S. Energy Information Administration (EIA) performed a study in Nov. 2014 concluding U.S. gas prices are more related to Brent than WTI. Further, the study noted U.S. crude exports could impact Brent prices and that gasoline is a globally traded commodity, so prices are highly correlated across global spot markets. The S&P GSCI Brent Crude and S&P GSCI (WTI) Crude Oil are highly correlated at 0.94 that shows the prices are highly related.

Historically, using monthly data back to Jan. 1988, the S&P GSCI All Crude (that is comprised of both WTI and Brent) has dropped in 156/336 months and the S&P GSCI Unleaded Gasoline has dropped in 127 of those 156 negative months, in other words they fall together about 82% of the time.  Also, generally, unleaded gasoline has moved slightly less than the all crude index, losing 5.9% on average in a negative oil month where the average oil drop is 6.7%, producing a down market capture ratio of 87.2, meaning unleaded gasoline drops about 87.2% as much as oil.  Conversely, in months when oil rose, it gained 7.1% on average but unleaded gasoline only rose 6.6% for an up market capture ratio of 93.1, meaning gas gains 93.1% as much as oil. Notice how closely unleaded gasoline and crude oil move together in the chart below:

Consistent with history, from the top of the oil market in June 2014 through the end of 2014, both oil and gas fell similarly, down 49.5% and 52.4%, respectively. The chart below shows this:

That’s a painful drop for both, but the producer holds more risk than the processor since the processor can make choices the producer can’t. For example, if prices fall, producers lose if they are unhedged; however, if the prices rise, processors can substitute or pass through price hikes to the retail consumer.

Gas refiners sure took advantage once the market turned up in the beginning of 2015 as it seems they needed to make up some of their losses from passing through savings on the cheaper oil. Now, the relationship changed. When oil gained just over 5% in the first six weeks of the year, unleaded gasoline increased almost 35% or seven times oil. Then as oil continued to rise another 10% through May, gas rose another 7%.  In total unleaded gasoline’s increase almost tripled the increase in oil. Since the peak, both oil and gas have dropped significantly, but the drop is more in-line with history with oil falling 38.9% and gas falling 41.2%. The net result is that unleaded gasoline’s drop is only half of oil’s for the year with gas down just 15.7% versus oil’s loss of 29.2%. This is shown in the chart below:

The result is that while oil is the cheapest in more than 11 years, since June 2004, gas is only at its cheapest in six years, since Jan 2009.  Based on the historical similarities, one might think their gas price should be 6% cheaper, back down to levels seen in 2004, rather than just back to 2009 levels.

Another place you can observe this relative refiner gain is in the market values of the energy stocks in the S&P 500 Energy Sector. As of Dec. 7, Valero, a major refiner, gained $9.4B in market value this year (+36%) versus a sector loss of $359B where Exxon lost $71B (-18%), followed by Kinder Morgan’s loss of $53B (-60%).

Again, this relationship is global. For example, in the UK, Morrisons has cut petrol to the lowest level since 2009. This level is precisely where the unleaded gasoline index level is now, so arguably this news is not a race for promotion ahead of the holidays. In fact, the news story points out that this drop is EXCLUDING SPECIAL PROMOTIONS. The price cut is just bringing Morrisons price to the global average. If the retailers really wanted to give you a deal, they might bring the gas price back in line to match the oil price drop, putting the price at 2004 levels. The retailers are keeping 5 extra years worth of pricing profits from the customers. Maybe the SPECIAL PROMOTIONS will offer the fair price of gas by passing through the whole oil price drop to the customers,