Investment Themes

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Make Room for a New Target Date Category

Oil’s Viscosity

Rieger Report: Factors impacting bond liquidity

When Diversification Fails

Valuing Low Volatility: Does Timing Matter?

Make Room for a New Target Date Category

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Philip Murphy

Managing Director, Global Head of Index Governance

S&P Dow Jones Indices

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Defined contribution (DC) plans, such as 401(k)s, place challenging demands on individuals, the highlights of which are to save diligently (which implies having adequate income, as well as budgeting abilities), to rationally select from among numerous investment vehicles, and to judiciously transition from wealth accumulation to income generation as retirement approaches. Innovations in plan design, such as auto enrollment and auto escalation, have helped with the first challenge. The introduction of target date funds, and other diversified investment alternatives, has helped with the second. But the retirement services industry and its clients—plan sponsors—continue to grapple with the last. The majority of 401(k) participants still do not have access to in-plan income solutions or, perhaps more importantly, to in-plan investments that integrate well with out-of-plan income solutions.

S&P DJI believes there is room in the target date industry for a new category, because it is possible to combine a glide path with a risk management framework, where the risk that one seeks to manage is the uncertainty of future income. Most people think of risk mitigation as managing the volatility of investment returns, or wealth level. However, investment drawdowns are not the only risk DC participants face as they seek to fund retirement consumption. A given amount of capital can fund some level of future income, but that level varies greatly, mainly as a function of prevailing interest rates, even though wealth may remain stable. In other words, a portfolio of T-Bills and high-quality, short-term bonds may provide stability of wealth, but may fail to provide stability of income purchasing power.

There are probably many plan participants and retirement savers for whom mitigating investment drawdowns, as retirement approaches, is an appropriate investment policy. However, there also may be many savers who have a need to integrate their investments with the funding of sustainable, inflation-adjusted future income. Often, this need goes unmet. With S&P DJI’s recent launch of the S&P Shift To Retirement Income and Decumulation (STRIDE) Indices, we hope to create a beachhead for new territory in the field of retirement investing. Nothing would please us more than to see popular fund rating shops like Morningstar and Lipper create a new target date fund category in the coming years that recognizes the risk management framework represented by the S&P STRIDE Index Series.

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

Oil’s Viscosity

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Kevin Horan

Director, Fixed Income Indices

S&P Dow Jones Indices

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Oil’s Viscosity

It goes without saying that if your car’s engine (or any other combustible engine) does not have the lubrication effect of oil then the friction of movement will lead to overheating and engine damage.

Currently oil is having its own effect on markets as low prices are leading to concerns of lower future earnings.  The current price levels of commodities suggest a possible economic slowdown not just for the U.S. but on a global basis.  China’s lack of demand for commodities and the recent stimulation of its economy is just another move in the ongoing central bank action that includes Europe and Japan.   European Central Bank President Mario Draghi said at a Jan. 21, 2016, press conference that “falling oil prices and a slowdown in emerging markets warrant a review and possible recalibration of the ECB’s policy measures in about two months”, as summarized by MarketWatch[1].

The following points are in regard to these comments.

Exhibit 1: Performance of S&P 500 Sector Bond Indices
S&P 500 Bond Index Sector ReturnsSource: S&P Dow Jones Indices LLC.  Data as of Jan. 22, 2016.  Past performance is no guarantee of future results.  Table is provided for illustrative purposes.

 

[1]   http://www.marketwatch.com/story/4-key-takeaways-from-draghis-no-limits-statement-2016-01-21

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

Rieger Report: Factors impacting bond liquidity

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J.R. Rieger

Head of Fixed Income Indices

S&P Dow Jones Indices

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Issuer name recognition and entity size seem to be factors in bond liquidity and as a result may be important considerations in index design.  Tracking the trade activity of corporate bonds issued by the ‘blue chip’ companies of the S&P 500 Index indicates liquidity is improved for these bonds over other bond issues.

Of course, when making decisions about depth of liquidity there are some important elements of the markets to consider:

  • There are many issuers of bonds and different types of issuers.
  • Some issuers borrow infrequently and others come to the bond markets with higher frequency.
  • Some issuers are well known entities to the investor community; others are smaller and less known.
  • Many  bonds can be issued from one entity, each with differing term structures (deal size, par amount, maturity, coupon, as well as redemption and security provisions to name a few).
  • Bonds are often buy and hold assets.
  • Bonds often represent long term obligations intentionally designed with maturities that match the useful life of the projects they fund.

Issuer name recognition and entity size as a factor can be illustrated by comparing the trade volume data of two indices: the S&P 500 Investment Grade Corporate Bond Index and the broader S&P U.S. Issued Investment Grade Corporate Bond Index.  Both have the same inclusion rules with the difference being the bonds in the S&P 500 Index must be bonds from the S&P 500 companies.

Table 1: Key index statistics as of December 2015:

Source: S&P Dow Jones Indices, LLC. Data as of December 31, 2015.
Source: S&P Dow Jones Indices, LLC. Data as of December 31, 2015.

What the data is telling us:

Table 2: Trade data statistics for June – December 2015

Source: S&P Dow Jones Indices, LLC and TRACE. Data as of December 31, 2015.
Source: S&P Dow Jones Indices, LLC and TRACE. Data as of December 31, 2015.

Please contact us to receive the time series referenced above.

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

When Diversification Fails

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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It has been the worst start in history for both stocks and commodities, and while rare, it is no accident.  Fundamentally, this environment is the worst ever.  It is like the demand crisis of 2008-9 combined with the supply war of 1985-6  – WITH a strong dollar. The oil drop from the peak in June 2014 is on the cusp of becoming the worst in index history, beating the 2008-9 drop.

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

What’s worse is the oil crisis has spilled into other classes. The jitters started with the Chinese stock market crash back in July that sent stock volatility soaring. The fears got worse when the Fed raised rates as evidenced by the spiking correlation between the risky assets, stocks and commodities.  The correlation now has quadrupled as stocks fall with commodities, erasing diversification benefits and making risk management difficult.

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

Today, there is a new risk-on/risk off based on rising interest rates. This is different than the risk on risk off we saw post the global financial crisis, since that one was from unprecedented quantitative EASING. One thing is the same – and that is the bi-modal view of either rising rates work – or they don’t. Right now it doesn’t seem like it’s working, so risk-off.

What are investors doing now?

Mostly 3 things that may diversify away from stocks and commodities. 1. Going to cash; 2. Going to gold – though not the same safe haven it once was, it does diversify. However, the rates need to be higher, the dollar needs to be weaker and inflation needs to kick in to support gold prices; 3. Including other real assets like infrastructure, property and inflation bonds to preserve capital while getting inflation protection.

The combination of real assets allows investors to get inflation protection without giving up portfolio efficiency. Since two of the worst oil drawdowns in history have happened in the past ten years, the inflation protection from commodities is no longer worth the performance losses from a diversification standpoint. The losses are so big that the low average correlation has not reduced the risk enough to justify the loss.

The inflation beta of natural resources (equities, fixed income and commodity futures) is 6.6 that is the highest of any single real asset. While the equity real assets composite has relatively high inflation beta, its correlation to inflation is relatively low. The S&P Real Assets Index that uses both stocks and bonds of infrastructure, property, natural resources plus inflation-linked bonds has the highest inflation protection combination.

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

Now that is attainable without giving up on diversification. When natural resources are added to a portfolio of stocks and bonds, the Sharpe Ratio, a measure of risk-adjusted return, falls from the poor performance. On the other hand, infrastructure may provide a nice diversification benefit but fails to provide as significant inflation protection. The solution may be to combine them for stronger and more consistent inflation protection and diversification through risk management provided by the mix of not only real asset categories but by the asset class mix, including bonds and commodity futures in addition to stocks.

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

Learn more about how this works by reading our paper at:

http://us.spindices.com/documents/education/lets-get-real-about-indexing-real-assets.pdf?force_download=true

For more information on real assets, I will be speaking  at Inside ETFs next Monday.

 

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

Valuing Low Volatility: Does Timing Matter?

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Fei Mei Chan

Director, Index Investment Strategy

S&P Dow Jones Indices

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If early January is any indication, 2016 should be another year when low volatility strategies will be in vogue. Popularized in the turmoil following the financial crisis in 2008, low volatility strategies, as the name denotes, serve well in times of equity upheaval. And despite bearing lower risk low volatility strategies have outperformed their benchmarks over time. The S&P 500 Low Volatility Index is an example of such a strategy. In the 25-year period ended in December 2015, Low Vol delivered an average annual return of 10.91% compared to 9.82% for the S&P 500 with less volatility (standard deviations of 11.04% and 14.44%, respectively). Year to date, Low Vol is outperforming the S&P 500 by approximately three percentage points.

However, as with any investment consideration, it’s prudent to look at a few fundamentals as a gauge of whether timing is opportune. Is it possible to isolate windows for which an entry point into Low Vol will offer most bang for the buck? To address this question, we look at the current S&P DJI Style model which utilizes book/price, sales/price, and earnings/price as value components. In the graph below, the red line (left axis) charts the performance spread between the S&P 500 Low Volatility Index and the S&P 500. The blue line (right axis) charts the value score of the low volatility index over time. Value scores are constructed relative to the overall market. By design, the S&P 500 has an average value score of 0. A positive value score reflects cheapness relative to the S&P 500. Conspicuously, Low Vol’s current value score has been hovering near all-time lows. If value is relevant, now would be an inauspicious time to get into Low Vol.

it's not always about timing

But, looking at history, Low Vol notched its highest value score (valuation was cheapest) in 1997 close to the onset of the technology bubble. Entry into Low Vol at that point would be followed by years of underperformance that would last through 2000. In contrast, one of the most expensive points of Low Vol was in the months following the financial crisis. That wasn’t too long ago but the red line in the chart above does a very good job illustrating what’s happened to Low Vol since then.  As a timing indicator, at least for Low Vol, value is not very valuable.

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