Indexology^® Blog

Some who follow target date fund (TDF) performance have taken note that lately, the S&P Target Date Index Series has outperformed many TDFs.  In most historical periods, index performance was middle of the pack.  However, 2015 was an exception, as shown in Report 2 of our Year-End 2015 Target Date Scorecard.  Every vintage of the S&P Target Date Index Series produced total returns that were close to, or better than, those of funds in the 90^th percentile of the target date mutual fund universe.

This story may seem like another chapter in the “index versus active” narrative, but it is particularly puzzling because of the methodology used to determine the benchmark asset allocation and glide path.  Every year, S&P DJI determines the asset allocation of each target date index vintage by compiling the holdings and asset-class exposure of a universe of active TDFs and using that data to create benchmark allocations reflecting average exposures of the active universe.  The benchmark therefore represents a consensus of asset-class exposure across its glide path; the average opinion, if you will, across the TDF industry.  I draw two conclusions from recent performance.

First, there is collective wisdom in the consensus.  There are a number of moving parts in every TDF suite.  Which asset classes are included?  What considerations inform the investment policy?  What assumptions are made?  How is the glide path expected to shift over time?  Which underlying funds are used to implement the investment policy?  What is the fee structure?  Whereas any individual TDF management team acts in response to an array of investment policy considerations, client interests, and self-interest, the consensus represents the wisdom of the crowd.  Collective thinking sometimes has superior value.

Second, it’s hard to beat a portfolio of index funds.  Single-asset-class managers and investors are challenged enough when it comes to beating cap-weighted benchmarks like the S&P 500^®.  The risk of active underperformance is increased when multiple funds are included in a portfolio.  Rick Ferri and Alex Benke demonstrate this effect in their paper, “A Case for Index Fund Portfolios.”

One final point about average performance: even if we never see another year like 2015, consistently achieving average performance is a more reliable way of compounding returns over time than alternately bouncing between outperformance and underperformance.  Perhaps tracking a market consensus glide path would be more enlightened than most industry insiders care to admit.

In 2015, the S&P BSE SENSEX remained volatile and ended in the red, at -3.68%.  In contrast, the S&P BSE India Government Bond Index ended the year in the black, at 8.33%.  The net investment by domestic mutual funds in the Indian equity and debt markets was significantly higher than the net investment by foreign investors.  Domestic mutual funds invested INR 721.98 billion and INR 4,340.99 billion in equity and debt markets, respectively.  Meanwhile, foreign investors added INR 178.08 billion and 458.57 billion, respectively.   Investors displayed mixed sentiments, let’s take a quick look at the performance of Indian large-cap equity funds from the latest SPIVA India Scorecard produced by S&P Dow Jones Indices and Asia Index Private Limited.

• Over the one-, three-, and five-year periods that ended in December 2015, 36%, 47%, and 57% of large-cap equity funds in India, respectively, underperformed the S&P BSE 100.
• Over the five-year period studied, the survivorship rate was low, at 70%, and the asset-weighted fund return was 103 bps higher than the equal-weighted fund return. This shows that the funds with a larger asset base had the advantage of the economies of scale over the five-year period.
• The return spread between the first and the third quartile break points of the fund performance was 4.59% over the five-year period, demonstrating that there was a wide dispersion in the returns of the funds in this category over this period.

Source: SPIVA India Year-End 2015 Scorecard.  Data as of Dec. 31, 2015.  Past performance is no guarantee of future results.  Table is provided for illustrative purposes.

For details on other periods and categories, please read the full report.

After China reported year-over-year first-quarter growth that showed signs of improvement, it overpowered negative news of the Doha oil production meeting failure and sent commodities rallying. Investors’ attention quickly shifted from oil to the other economically sensitive sector, industrial metals.

Many believe the uses for metals in construction and automobile manufacturing are the driving force behind the sector. Copper even earned its nickname “Dr. Copper” for its supposed ability to indicate the economic health of China. However, data shows Dr. Copper is not so smart and that this rally is from the weak dollar and supply shocks rather than Chinese GDP (gross domestic product) growth.

The first myth is that copper and industrial metals are correlated to economic growth, especially China’s. Using year-over-year data since 1978, the correlation of copper to Chinese GDP growth is only 0.21, and is actually the lowest of all the industrial metals. The most correlated metal is zinc but the relationship is still weak at only 0.28.

Even if Chinese demand might not be enough to boost the metals, there is still hope for the sector.  The correlation of metals to the US dollar has a higher (and inverse) relationship than to GDP growth, but the correlation is still only moderate.

However, the weakening dollar helps metals more than any other commodity sector. In the past 10 years, for every 1% move down in the US dollar, gains in lead, nickel, copper, zinc and aluminum have been 7.2%, 6.1%, 5.3%, 4.6% and 2.2%, respectively. Also, silver has gained 6.0% and gold has gained 3.5% for every 1% slip in the dollar.  The weak dollar helps far more than a strong one hurts.

Besides the tailwind of a weakening dollar, there are noticeable shortages that have appeared. March was the first month the industrial metals sector was in backwardation since September 2015 and marked the third time in 18 months – that hasn’t happened since 2007, before the financial crisis.  

Within the sector, there have been recent shortages in industrial metals from lead, copper and aluminum. While copper has more shortages than excess inventories throughout history, its roll yield has grown (measuring a shortage) 60% in the first quarter. Also, lead showed a shortage in Feb for the first time since Nov. 2012, but now is a seasonally weak time for lead as the winter demand for replacement automobile batteries slows. However, the support for aluminum could be more persistent from stockpiling and tax policies. It is very rare to see shortages in aluminum. There have only been 10 months in 10 years with a positive roll and it seems to be driving the whole sector. 

Notice the dramatic decline over the year in warehouse stock levels too.

Zinc has gained more than gold this year and is the best performer in the sector, up 20.5% in 2016. Its excess is half of what it was in October.  Supply cuts and mine closures have boosted returns. “Zinc inventories dropped for a 28th straight session to 413,250 metric tons, the lowest since August 2009, as supply cuts and the closing last year of China’s MMG Ltd. Century mine and Vedanta Resources Plc’s Lisheen mine boosted the need for supplies on exchanges. Chinese new-home prices rose last month in 62 of 70 cities tracked, compared with 47 cities in February, helping boost the demand outlook for the metal.” –  According to Bloomberg, stockpiles are the lowest in more than six years.

Nickel hasn’t seen a shortage since 2011, despite its huge price spike in 2014 of more than 50%. The suppliers are producing relentlessly to try to squeeze out marginal producers for market share – much like what is happening in the oil market. Except the role of China is flipped. Nickel producers want to squeeze China out, yet China is the oil customer everyone wants.

So, the story isn’t as simple as “Chinese demand growth boosts copper (or industrial metals).” While the demand growth may help, the dollar and supply side are the more important factors for the sector. If the demand grows at the same time the supply is disrupted and the dollar is weak, it may be a best case scenario for the industrial metals.

Emissions of carbon dioxide and the other greenhouse gasses are often foremost in people’s minds when they consider environmental risk.  This is understandable as, if we continue on our current path, we are set for four degrees Celsius of warming by 2100, compared with pre-industrial levels.  Expected consequences include the flooding of coastal cities, irreversible loss of biodiversity, severe heat waves, and high-intensity tropical cyclones.  2016 has seen Arctic sea ice at its lowest seasonal maximum in satellite records, so warming is already having significant impacts.

Following COP 21 in Paris, we at Trucost have seen a significant uptick in interest from mainstream financial institutions, asset owners, and managers, and the vast majority of this increased attention is focused on carbon.  This is also reflected in recent legislation, such as the Energy Transition Law in France, which will quadruple the country’s carbon tax for fossil fuels by 2020, and the State Bill in California, which requires the California Public Employees’ Retirement System and the California State Teachers’ Retirement System to divest from companies that receive at least one-half of their revenues from coal mining.

However, investors may want to make sure that carbon is not the only environmental factor they consider.  It is clear, for example, that water is increasingly becoming an investment issue.

According to the World Meteorological Organization, global water consumption increased by six times between 1900 and 1995.  The UN Population Division predicts that water scarcity will increase to between 50% and 65% by 2025.  Insufficient access to clean water can significantly disrupt operations, increase costs, and curtail growth.  Despite increasing risks to businesses and communities, the cost of water today in many regions of the world remains relatively low.  Just as carbon emission costs are now increasing, one could expect water prices to follow suit.

It is possible that the correction of this price anomaly will have huge consequences for businesses.  Trucost has calculated that more than one-quarter of the profits of the world’s biggest companies would be wiped out if water were priced to reflect its value.  Exhibit 1 shows the impact on a per-sector basis.  Agriculture would be particularly affected, as it accounts for two-thirds of total freshwater withdrawals (Berggren, 2014).

In research on how this may already affect companies’ financial returns, Trucost undertook an analysis to compare the food and beverage companies in our database, based on the amount of water they used though their supply chains.  When we compared the top quintile (least water used) versus the sector average, we found the top quintile companies outperformed the average by 3%.

There are water risks and rewards to be discovered in investment portfolios, and now could be a good time to make sure they are measured correctly.

For additional information please see S&P DJI’s papers on Resource Efficiency: A Case Study in Carbon and Water Usage and the inaugural Carbon Emitter Scorecard, published in collaboration with Trucost and utilizing Trucost data.

As far as equity investors might experience them, the risks of a potential “carbon tax” are more easily fathomed than the rewards.  Emissions data are available for most large companies and – taking basic assumptions on the likely form of taxation – we can easily examine which market segments face the greater risks.

Estimating The Impact of a Carbon Tax

In comparing tax sensitivity, the key comparison becomes one of efficiency. This is provided by a “revenue footprint”­, which is calculated for each company as the total emissions per U.S. $1 million dollars of revenue.  This, combined with an appropriate benchmark, allows for a revenue footprint to be calculated for overall markets, or segments, based on the characteristics of each component.

To provide an estimate of the tax liability, we assume a hypothetical flat rate of tax equal to $25 per tonne of carbon dioxide – a reasonable estimate if we rely on what has been proposed or implemented elsewhere in the world.  Combining this with the revenue footprint for the main regions and sectors composing the S&P Global 1200, we arrive at an estimated tax liability (per $1M of revenues) as follows:

There is not a great deal of distinction between the different geographies.  Our Latin American benchmark faces the largest tax bill in proportion to revenues, followed by Australia and then the United States, but the bulk of major indices face a tax bill roughly in the range of 0.5% to 1.0% of revenues.

The variation among global sectors is far more dramatic, with several orders of magnitude separating the best, from the worst.  It is perhaps surprising that Energy is less at risk under this analysis than to both Utilities and Materials, although this highlights that it is the actual burning of fossil fuels, opposed to their extraction, that results in emissions.

Value Investors Could Be More At Risk Than Growth

This approach – of using a “revenue footprint” in combination with an estimate of likely taxation to measure risk – is not limited in application to sectors, or regions. Provided that the allocations are reasonably stable, a similar analysis may be conducted on any index, or portfolio. This allows us to make comparisons between, for example, growth and value investment styles.  Common sense suggests that the archetypical “value” company will be more carbon intensive: they are associated with significant fixed assets like factories and land, while growth archetypes are found in technology, capabilities, and intellectual property.

Indeed, based on a global classification of “growth” and “value” (as provided by the S&P Global BMI style indices), the results show a clear relationship between value/growth classification and potential tax risk.  Overall, value investments face likely tax bill that is around 50% higher as a proportion of revenues.

Conclusions

We don’t know whether a global carbon tax is coming, or what form it will take even if it comes.  But without it, it will be hard for national governments to meet the commitments they have made, especially as “big business” is only a small part of the problem.  And while investing in different markets across the world might result in a lower sensitivity to a putative carbon tax, a closer examination, particularly of sector exposures and growth/value tilts, may prove more useful in assessing the risks.

For more details on how the revenue footprint is calculated for each company, and index, as well as further analysis of the relative and absolute landscape of corporate emissions, see our inaugural S&P Dow Jones Indices Carbon Emitter Scorecard.