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Volatility, Short- and Long-term

Resource Efficiency: A Step Beyond Climate Change

Defaults Are on the Rise

What the Beige Book Hints About the Fed

The Role of Quality in Long-Term Value Creation

Volatility, Short- and Long-term

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Craig Lazzara

Managing Director and Global Head of Index Investment Strategy

S&P Dow Jones Indices

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This morning’s Financial Times highlighted a study of market volatility suggesting that return and volatility are inversely related — that “the correct response to an increase in volatility…is to exit the market.”

This is certainly true in the short run, as the table below confirms.

Source: S&P Dow Jones Indices.  Monthly total return data for S&P 500, 1991 - 2015.  Table is provided for illustrative purposes.  Past performance is no guarantee of future results.
Source: S&P Dow Jones Indices. Monthly total return data for S&P 500, 1991 – 2015. Table is provided for illustrative purposes. Past performance is no guarantee of future results.

In months when the realized volatility of the S&P 500 was above average, the index’s total return was -0.03%.  When volatility was below average, the index’s average return was a much-improved 1.74%.   And regardless of whether realized volatility was above or below its midpoint, the S&P 500 tends to do much better when volatility is falling rather than rising.

But these are very short-term — indeed, monthly — effects.  What happens when we look beyond a one-month holding period?   Using the history of the Dow Jones Industrial Average (which extends back to 1896), we calculated returns for holding periods of various lengths, conditioned on whether volatility was above or below the 85th percentile of the distribution.  Given what we’ve already observed about the relationship between high volatility and low returns, it’s not surprising that investments made during periods of lower volatility outperform over short holding periods (up to about 11 months).  After that, however, fortune favors the bold:

Source: S&P Dow Jones Indices LLC, The Landscape of Risk, 2014.  Data from July 1896 to September 2012.  Charts and tables are provided for illustrative purposes.  Past performance is no guarantee of future results.

Source: S&P Dow Jones Indices LLC, The Landscape of Risk, 2014. Data from July 1896 to September 2012. Charts and tables are provided for illustrative purposes. Past performance is no guarantee of future results.

The British financier Nathan Mayer Rothschild is reputed to have said “Buy when there’s blood in the streets, even if the blood is your own. The saying may be apocryphal, but the insight it embodies is real enough.  One investor’s short-term risk can be the basis for another’s long-term gain.

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

Resource Efficiency: A Step Beyond Climate Change

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Daniel Ung

Director

Global Research & Design

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In recent years, there has been much focus on the importance of climate change and how much greenhouse gas is produced in the process of conducting business.  While managing greenhouse gases is an important focus, is the future more about increasing efficiency across different depletable resources, such as water?

Because the demand across different scarce resources is correlated, it may be sensible to adopt a holistic approach when managing the efficiency of these resources rather than a disjointed, piecemeal approach.

In the research paper Resource Efficiency: A Case Study in Carbon and Water Use, we investigated whether or not there was an impact on the financial performance of carbon-efficient companies (i.e., companies that generate the least amount of greenhouse gases per U.S. dollar of revenue) and resource-efficient companies (i.e., companies that are efficient across their water use and greenhouse gas emissions).

Despite the limited availability of data, our preliminary findings suggested that, on average, efficient companies (Quintile 1) outperformed inefficient ones (Quintile 5) over a rolling 12-month or rolling forward basis (see Exhibit 1).

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In addition to this, there are other reasons why carbon and resource efficiency are important.  If companies do not promote efficiency in their business activities, some of the risks they may face could adversely affect their future profitability.  For example, there are risks associated with increased regulation, resource depletion, reputation, and financing.

For more details on the results of our research, please click here to access the research paper.

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

Defaults Are on the Rise

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Jason Giordano

Director, Fixed Income, Product Management

S&P Dow Jones Indices

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The March rebalancing of the S&P U.S. Distressed High Yield Corporate Bond Index saw another increase in the number of qualifying constituents.  This marks the eighth increase of this kind in the last nine months.  The index, which is designed to measure securities with an option-adjusted spread greater than or equal to 1,000 bps, is down 35% over the past one-year period as of March 1, 2016.

While the monthly change in constituents saw a net increase of 53 issues, there were actually 137 new issues that entered the index universe.  Seventy issues were removed from the index as a result of improved credit spreads; however, 14 issues were removed from the index due to default.

Of the 14 issues in default, 10 were in the energy sector (five issuers), while four represented the materials sector (four issuers).  Combined with January’s activity, 14 issuers have been removed from the index due to default this year.  In comparison, there were 64 issuers that defaulted in all of 2015.

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New issues added to the index had a total par amount of over 80 billion (approximately 15% of the index value).  The total par value of the index has increased 300% since July 2015.

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Not surprisingly, the energy sector is the leader for both number of issues added and percentage of par amount added to the index.  There were a total of 72 issuers that were added to the index with representation from all 10 sectors.

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

What the Beige Book Hints About the Fed

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David Blitzer

Managing Director and Chairman of the Index Committee

S&P Dow Jones Indices

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The latest copy of the Beige Book, the Federal Reserve’s survey of the economy, was released today in preparation for the next FOMC meeting on March 15th-16th.  The picture it paints of the economy is far better than what one might assume from the stock market’s recent gyrations – but probably not good enough to support another increase in the Fed funds rate this month.

Residential and commercial real estate are the strong spots in the economy while energy and agriculture are the weak ones. Consumer spending is rising in most places, nonfinancial services are reporting gains and manufacturing is flat to slightly positive. Auto sales are good in most areas. Export activity is hurt by the strong US dollar and lackluster economies among major trading partners.  Recent data support this. Home prices continue to rise and sales of existing homes are strong, consumer spending and personal income in January was better than expected and the Institute of Supply Management index for manufacturing rose in February. Labor markets are reported to be improving, consistent with the ADP payrolls number released this morning. Wage gains vary across the country and prices are generally flat according to the Beige Book.

The Fed’s decision on when to raise interest rates is should it take the generally positive beige book and recent better-than-expected economic reports as a reason to move soon, or should it be worried about the stock market’s two months of turmoil?  The chart puts this into a picture: the steady growth of nonfarm payrolls vs. the S&P 500 ups and downs.

Inflationary expectations are low and the Fed’s principal inflation gauge – the core PCE deflator – is under its target. Nothing in the Beige Book makes a case for an immediate Fed rate hike at the upcoming meeting.  Hopefully the FOMC statement on March 16th will have some hints for the future and be interesting reading.

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

The Role of Quality in Long-Term Value Creation

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Kelly Tang

Director

Global Research & Design

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This is the third in a series of blog posts relating to the launch of the S&P Long-Term Value Creation (LTVC) Global Index.

In the last blog, we discussed how long-term investing requires looking at metrics that go beyond the standard GAAP financial accounting measures and why the Economic Dimension (ED) score from RobecoSAM was the sustainability score that best complimented the long-term aim of the S&P LTVC Global Index.  While the ED score may be a key metric of a firm’s long-term focus on its goals, it is also important to the index to identify how these policies have translated themselves and are reflected in the quality of a company’s earnings, balance sheet, and profitability.

It is safe to say that the definition of quality and the characteristics of a high-quality company will generate numerous and varied responses from academics and analysts alike.  In addition, the difference in opinion will persist in not only the definition, but also the number of metrics that should be used to gauge quality.  Our colleagues previously examined the quality debate and presented their findings and S&P Dow Jones Indices’ stance in “Quality: A Distinct Equity Factor?” (Ung and Luk).  The paper presented the framework for defining quality which included categories such as profitability, earnings quality, and strength in balance sheet.  The report included back-tested performance results, which showed that the proposed quality factor was beneficial in contributing to excess long-term investment returns.

Quality Factors

For the S&P Quality Indices, the following three metrics are used to define a quality company.

  1. Return on equity (ROE) was selected as the preferred metric for profitability, and companies with higher ROEs have sustained competitive advantages such as branding or competitive positioning, which help them maintain their profitability.
  2. Quality of earnings was another criterion to determine quality as measured by the balance sheet accruals (BSA) ratio (change in net operating assets/average operating assets). The BSA provides a way to measure how a firm scores in its earnings management; higher accruals are a potential red flag as higher levels of noncash items may lead to financial statement revisions.
  3. Finally, the financial leverage ratio was selected as the third metric to gauge balance sheet strength, with the rationale that high-quality companies have the ability to finance their ongoing business activities without having to incur excessive debt levels, protecting them in times of crisis.

One of the key findings from Ung and Luk’s paper was that although quality strategies have performed well on their own, they appeared to work well when combined with other factor strategies as well.  This was the basis for our thinking to combine quality with economic sustainability factors to create the S&P LTVC Global Index.

In our final blog of the series, we will dig deeper into the unique structural aspects and performance attributes of the S&P LTVC Global Index.

 

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