Indexology^® Blog

The spread between the returns of the S&P GIVI Japan and its benchmark index, the S&P Japan BMI, comes from three sources: the excess return of the S&P Low Beta Japan Index; the excess return of the S&P Intrinsic Value Weighted Japan Index; and a residual effect that comes from the sequential approach to the index’s construction.  Looking at the low beta and value legs individually may help market participants to understand the performance of the S&P GIVI Japan better.

Performance

The S&P Low Beta Japan Index and the S&P Intrinsic Value Weighted Japan Index outperformed the S&P Japan BMI by 2.42% and 2.79%, respectively, over the period from Dec. 31, 1999, to June 30, 2016.  Over that time period, however, there were cycles in the performance of the two legs and the correlation coefficient.

Exhibit 1 provides a visual illustration of the relative performance of the two legs versus the S&P Japan BMI.  The value premium seems to be compressed in Japan over time.  We see for the first time in June 2016 that the S&P Intrinsic Value Weighted Japan Index underperformed the S&P Japan BMI over a rolling five-year period.  The low beta leg tended to outperform during down markets and underperform during up markets.  In the bull markets from 2H 2012 to 1H 2015, however, the low beta leg had a counterintuitively strong performance.  The low beta leg continued to do well when Japanese equity markets were down, starting from 2H 2015.

Please refer to S&P GIVI Japan and Major Single Factors from July 2016 for a performance analysis since the launch of the indices.

Correlation

Exhibit 2 shows the rolling three-year correlation coefficient between the two legs.  The full period correlation coefficient between the two legs is 0.35.  Over the seven-year period ending June 30, 2016, there seems to have been a much lower correlation (-0.15).  Given the performance of these two legs since end of 2012, the correlation between them has declined dramatically.  As of June 30, 2016, the correlation was at -0.54, the lowest level since the end of 1999.

Valuation

The recent performance also significantly pushed up the valuation of the S&P Low Beta Japan Index.  As shown in Exhibit 3, the S&P Low Beta Japan Index was priced at 15.41x projected earnings and 1.30x book value as of June 30, 2016.  This was much higher than the 13.63x and 1.12x, respectively, of the benchmark, the S&P Japan BMI.  We should note that the valuation of the S&P GIVI Japan was still more favorable compared with the benchmark.

The story of Asian fixed income remains compelling, and select Asian bond markets recorded strong growth and solid performance in 2016.  Most Asian currencies strengthened with the news of the Brexit, which may further improve sentiment among market participants.  Asian bond yields, though tightened, are still at an elevated level compared with their global peers.  Particularly in this global low-to-negative interest rate environment, Asian bonds are attractive, as the theme of yield hunting continues.

Looking into the 10 countries in the S&P Pan Asia Sovereign Bond Index, the highest-yielding market was India (at 7.50%), followed by Indonesia (at 7.40%), see exhibit 1.  In fact, the S&P Indonesia Bond Index was the outperformer in the region in 1H 2016, delivering 12.90% total return YTD as of July 7, 2016.  The S&P BSE India Bond Index gained 5.99% during the same period.

The yield-to-maturity of the S&P China Bond Index was 2.79%; it was the highest among the Asian countries rated ‘AA-.’  Yet the total return index only added 1.73% YTD, making it the second–worst-performing country in the Pan Asia region.

The S&P Hong Kong Bond Index was the underperformer, as it was up 0.67% YTD.  Its sovereign yield was 0.53%, which also the lowest among the 10 countries.

Exhibit 1: Asian Sovereign Yields

Payrolls jumped with 287,000 new jobs in today’s employment report sparking a stock market rally that boosted the S&P 500 to within five points of a new record high and renewed questions about a Fed rate hike. The employment report was welcome and put to rest worries that the labor markets were weakening. However, the Fed is likely to remain on hold until the fourth quarter or longer. Even with this report, job growth is easing a bit: over the last three months job growth has averaged 147,000 per month compared to 199,000 per month over the 12 months through June.  The labor force participation rate and the employment population ratio remain flat; the unemployment rate ticked up to 4.9%.  Labor market conditions look better than they did before the report, but the overall picture is little changed.

The big cloud on the horizon is neither the labor market nor inflation – it is the expected fallout from Brexit.  From the last FOMC minutes it is clear that the Fed, like almost everyone else, is trying to figure out what happens next in Great Britain and Europe. A few things can be identified and are likely to discourage any early Fed action to raise interest rates. First the dollar’s strength may dampen US exports and put further downward pressure on inflation, deterring any thoughts of a rate hike. The larger concern is that financial markets may react the way they did when the vote was announced, adding to uncertainty and volatility. Moreover, Brexit may be dominating the headlines but there are other issues across Europe with concerns about debt levels and banks. All this suggests that stable monetary policy is a better choice than trying to raise interest rates.

For investors and the Fed it is a wait and see game. Those who like rock bottom interest rates are likely to enjoy them for a while longer.

Following the vote by UK citizens to officially leave the European Union, the S&P 500 lost 5.3% in 2 days (Jun. 24-27, 2016) before gaining back 4.5% for a total loss 1.1% through July 5.  In those two down days, gold posted its best consecutive 2-day gain since Aug. 8-9, 2011.  Gold is known as a safe haven and was worth its weight on those fearful days, but on a stand alone basis, it is just as volatile as equities and other commodities. Its 10-year annualized volatility is 19.5%, that is just slightly less than the 20.5% of the S&P 500 and 23.8% of the S&P GSCI. Moreover, gold’s volatility is higher than the equally weighted Dow Jones Commodity Index (DJCI) of 17.9% and the “smart beta” Dow Jones RAFI Commodity Index of 16.4%.

While indexing has evolved to offer concentrated exposures to particular sectors or single commodities so investors can choose to invest or benchmark to a specific niche, many investors still prefer the diversification inside an index. However, just because an index is well-diversified it does not need to be exposed to systematic risk of the S&P 500 or market events like Brexit.

There is a group of well-diversified indices that didn’t just lose less than the S&P 500 or S&P GSCI, but posted gains in the 2-day crisis. The strategic futures index family is designed to represent the global macro and managed futures/Commodity Trading Advisor (CTA) universe by using quantitative methodologies to track the prices of a globally diversified portfolio of commodity, foreign exchange and financial futures contracts. All three flagship indices in the family, the S&P DFI, S&P SFI and S&P SGMI, gained on Jun. 24-27, 2016, 0.8%, 1.0% and 2.2%, respectively.

Not only did these three perform positively through the stock market decline but they held onto their gains for an overall positive return while stocks rebounded.  They didn’t rebound as much as the 4.5% gain from the S&P 500 but the S&P SGMI gained 1.8% while the S&P SFI and S&P DFI lost just 10 and 70 basis points.  Overall through the 7-day period, when the S&P 500 lost 1.1%, the S&P SGMI gained 4.0%, S&P SFI gained 1.0% and S&P DFI was up 0.1%.

These strategies performed exactly how intended with downside protection and less upside for a total return with less volatility and capital preservation.  The 10-year annualized volatility of the S&P SFI is just over a quarter of the S&P 500. The S&P SGMI, which is the most volatile of the family is still only about half as volatile as the stock market, and annualized over the past 10 years provided a comparable return of 7.1% versus 7.4% of the S&P 500.

It may be surprising that these strategies use commodities, but in a diversified framework like in the S&P Real Assets Index and smarter commodity strategies like in the Dow Jones RAFI Commodity Index, the strategic futures that go beyond just commodities can provide an attractive hedge to stock market volatility without the high concentration risk of sectors or single commodities.

Publicly traded property stocks provide exposure to real estate, an illiquid asset class, without sacrificing the liquidity benefits of listed equities. Also, property stocks typically offer higher yields than the broad equity market, they may serve as an effective inflation hedging tool, and they may help diversify a portfolio due to their generally low correlations to stocks and bonds.

S&P Dow Jones Indices and NZX Limited jointly launched the S&P/NZX Real Estate Select in October 2015 to serve as an investable benchmark for real estate companies listed on the NZX. The index is designed to track the largest, most liquid property companies included in the S&P/NZX All Index. To reduce single-stock concentration, the index employs a semiannual stock cap of 17.5%.

As depicted in Exhibit 1, total returns of New Zealand equities, as measured by the S&P/NZX 50, and property stocks, as measured by the S&P/NZX Real Estate Select, have been relatively similar over the longer term, while volatility has been modestly lower for property stocks. This is somewhat surprising given that global property stocks tend to have meaningfully higher volatility than the broader global equity market.  As expected, investment-grade bond returns have been more modest, but they have been much less volatile compared to both equities and property stocks.

As shown in Exhibit 2, the S&P/NZX Real Estate Select has historically had relatively low correlations to both the S&P/NZX 50 and S&P/NZX Composite Investment Grade Bond Index. In fact, the correlation of 0.48 between New Zealand equities and New Zealand property stocks is equivalent to the correlation between New Zealand and global equities.

Exhibits 3 and 4 illustrate the potential diversification benefits of adding a listed property allocation to a stylized equity or equity/bond portfolio over the past five years. For example, a hypothetical 80%/20% combination of the S&P/NZX 50 and S&P/NZX Real Estate Select resulted in a meaningful reduction in volatility compared to a 100% position in the S&P/NZX 50.  This was driven both by the lower risk profile of the S&P/NZX Real Estate Select as well as the relatively low correlation between the indices.

Similarly, adding a 10% listed property allocation to the equity portion of a 60% S&P/NZX 50 and 40% S&P/NZX Composite Investment Grade Bond Index portfolio resulted in a further reduction in volatility and higher risk-adjusted return over the trailing five-year period.