Indexology^® Blog

I have few memories of my school French, but one of the fondest is of Moliere’s Monsieur Jourdain, who was delighted to learn in middle age that he had been speaking prose for the last 40 years.  Similarly, I did not realize until recently that I was a “passivist,” as the Wall Street Journal has now anointed the advocates of passive investment.

Upon reflection, I’ve concluded that passivists are made, not born, and they’re made not by theoretical argument but rather by a series of empirical observations.  The first of these is that most active managers fail most of the time, at least if we define “success” as active outperformance of passive benchmarks.  This is powerfully illustrated by our SPIVA scorecards, but the observation that most active managers underperform is not new and is hardly original to us.  Charles Ellis identified active management as a “loser’s game” more than 40 years ago, and more than 40 years before that, Alfred Cowles made a similar argument.

Second, when active success occurs, it tends not to persist.  Our persistence scorecards demonstrate that an investor has a better change of flipping a coin and getting four heads in a row than he does of identifying a fund manager who will be above average four years in a row.  This observation about the population of active managers does not mean that individual managers cannot be exceptions; famous examples like Warren Buffett and Peter Lynch come immediately to mind.  But Buffett and Lynch are famous precisely because they are exceptional.  If most active managers could outperform consistently, we wouldn’t know the names of the handful that do.

Third, a new generation of index products makes it possible to indicize strategies which were formerly the exclusive preserve of active managers.  Smart beta or factor indices provide exposure to a wide range of additional factors which investors may find attractive.  Importantly, factor indices make life more challenging for active managers.  Consider, e.g., an active manager who historically has tilted away from his cap-weighted benchmark in a systematic way (perhaps by emphasizing value, or small size, or low volatility).  The manager’s clients have had no way of disentangling how much of his performance is attributable to factor tilts and how much is attributable to stock selection beyond the factor.  Now, factor indices make it possible for the client to obtain access to the factor itself, without the manager’s stock selection, and to do so transparently and at low cost.

These observations mean that the ranks of the passivists are likely to continue growing.

Global events this year have been transitional in nature, signaling change.  Examples of significant developments include the result of the Brexit vote, with the UK officially set to leave the EU and the new Prime Minister, Theresa May, preparing for upcoming changes, as well as the 58^th U.S. Presidential election, which is empowering electors to choose their 45^th president.

We are witnessing changes in passive investing as well.  Q3 2016 reached a record high USD 3.408 trillion in ETF/ETP assets listed globally.  Third quarter statistics showed the global industry at 6,526 ETFs/ETPs, with 12,386 listings from 284 providers listed on 65 exchanges in 53 countries.[i]

This growth in passive investing has been fueled by a number of factors, including technology, regulation, costs, and doubts about the persistence of active fund manager performance.  Economies of scale and advanced technology have put fees under pressure.  Increased transparency and regulation have also set the ball in motion.  There appears to be a growing realization of the scope of products and options that passive routes can provide, along with growing popularity of smart beta and factor investing.

ETFs are an innovation that potentially lower costs as a result of fewer intermediaries, reduced administration expenses, lower marketing costs due to the availability of online platforms, and a move toward increased automation.  Robo-advisory has also become more prominent, and index-based investing may be the greatest beneficiary.

Pure passive strategies are now being challenged with lower a cost, which aids the implementation of core-satellite strategies.  Many market participants use this strategy to manage their investment strategy, either keeping their core passive and satellites active or vice versa.

In India, the trend of passive investing is growing.  Although market conditions are still offering alpha to active fund managers, some market participants are moving toward index-based investing. We are seeing this shift if they are interested in market beta or a passive approach, to apply certain investment selection factors in order to offer differential options.

The growing scope of passive investing could increase the smart beta space.  Global assets in smart beta have seen growth of nearly 40% from 2010 to 2015.[ii]  Smart beta investing, simplistically defined as investment strategies that consider factors such as low volatility, quality, momentum, value, etc., may provide low cost and transparent, easy access to return that was previously believed to be available from active management only.

So can we expect an actively growing passive space?  Let us wait and watch.

[i]   etfgi.com

[ii]   etfgi.com

High beta, value factors among the star performers, while low volatility lags amid heightened appetite for risk

The high beta, value and size factors outperformed the broad-market S&P 500 Index by a sizeable margin during the third quarter, with the S&P 500 High Beta Index gaining 12.18% during the three-month period – outpacing all other factor indexes. The S&P 500 Index rose a healthy 3.85%, but 14 smart beta strategies and two smaller-cap indices – the S&P SmallCap 600 Index and S&P MidCap 400 Index – all outperformed the broader market.

There was a nearly 14.70% total return gap between the best-performing factor (high beta) and the poorest-performing factor (low volatility) during the third quarter. This dispersion was greater than the second quarter’s performance gap, but less than that of the first quarter, which saw significant market volatility. Year-to-date, there has been an even wider performance chasm from top to bottom, with the Nasdaq Dividend Achievers 50 Index up 22.6% and the Russell Top 200 Pure Growth Index down 0.22%. This dispersion underscores the differentiated return streams of factor-based strategies.

As you can see from the performance table above, some of the worst performers in the first quarter of the year turned out to be the best performers in the third quarter. Conversely, some of the best performers in the first quarter lagged in the third quarter. This is not unusual and again speaks to the diversification potential of factor-based strategies.

During the third quarter, the high beta factor benefited from heavy exposure to financials and energy stocks and limited exposure to utilities and consumer staples. Value-based strategies, represented by the Russell 2000 Pure Value Index and the Russell Top 200 Pure Value Index, also had significant exposure to financial and energy stocks, which boosted their returns.

High beta and value strategies were also buoyed by an improved economic backdrop. The ISM Index, considered a barometer of US industrial activity, jumped from 52.7 in May to 56.1 in June – its highest level since October 2015. Moreover, non-farm payrolls rose by more by than 270,000 in both June and July.

Narrowing credit spreads hint at increased risk tolerance
The improved outlook for economic growth led to a drop in high yield credit spreads during the quarter. The BarCap U.S. Corporate High Yield-to-Worst 10-year Treasury spread fell from 5.81 to 4.58, while the US 10-year Treasury yield bottomed out at 1.32% on July 6.¹ Volatility, in the form of VIX, eased during the third quarter, falling from 15.63 to 13.20.¹ Although the economy appeared less vibrant in September, a bias toward higher interest rates, a downward slant in high yield spreads and benign volatility were all favorable for investor risk taking.

Macro factors may not completely explain the favorable impact of energy exposure on value stocks and high beta based indices; stock selection was also important to energy sector returns. The 12-month Bloomberg Nymex Crude Oil Strip 12-Month Strip Futures Price Index finished the quarter at $50.46 – down marginally from Q2, but still above $50 for the second consecutive quarter. The rebound in oil prices coincided with OPEC’s decision to cut production in late September.¹

Year-to-date, the Nasdaq Dividend Achievers Index has been the strongest performer – driven by energy and utilities and solid stock selection in financials, staples and industrials. The combination of dividend growth and yield was positive during the first half of 2016, and led to only slight underperformance in the third quarter.

What’s behind the performance of high beta stocks?
The strong quarterly performance of high beta stocks makes sense when you consider that high beta can outpace low volatility during periods of rising 10-year Treasury yields and stronger economic growth, when investor demand for defensive stocks may ease. The charts below depict this relationship.

Despite a narrowing election race and a deluge of earnings, the S&P 500 has not seen a daily change greater than 1% in nearly four weeks.  Realized volatility remains remarkably low.  But the CBOE Volatility Index (VIX) – a predictive measure of future volatility that is often seen as Wall Street’s “fear gauge” – has nearly doubled in the same period.  Is it the calm before the storm, or has VIX just got the jitters? 

Presently, the difference between VIX and S&P 500 realized volatility is highly significant. November 3^rd’s closing VIX was 22.1 – nearly triple the S&P 500’s trailing volatility of 7.1.  A VIX higher than realized volatility is not unusual, especially when realized volatility is low, but the spread  between VIX and realized volatility has reached extremely rare levels.

The gap between VIX and realized volatility has been greater than 15 on only a handful of occasions in the past quarter century.  In most cases, an impending political event was the cause of the elevated VIX, and intriguingly, the subsequent performance in the S&P 500 was more commonly positive than negative.

The table provides grounds for optimism: with so much fear in evidence, one might assume that the current level of the S&P 500 reflects a discount for the market’s fears of a disruptive election result, not the current economic reality.  And indeed the day-to-day economic news has been encouraging: earnings have been largely positive and as far as the U.S Federal Reserve sees it, a case is easily made for the bulls.

But we may well ask “what if the pollsters and the betting markets – both of which are currently indicating a win for Hillary Clinton in the election – have it wrong?”

Volatility markets have precedent for predicting surprise results: it is notable that the spread from VIX to realized S&P 500 volatility rose as high as 13 on the day before the UK referendum in June.  In fact, the market’s anxiety over a potential vote to leave the EU was telegraphed in the currency volatility markets as much as three weeks before polling day.

Trump’s protectionist trade policy and political populism have drawn comparisons with the “Brexit” campaign, and the behavior of volatility markets in advance of the vote provides a further similarity.  If Trump does indeed win, we cannot claim that the VIX didn’t warn us. 

Given that our crystal balls are opaque for predicting interest rates, I thought it would be interesting to continue my interview with two financial advisors about managing interest rate risk in the municipal bond asset class.

Matt Papazian is founding partner and CIO at Cardan Capital Partners of Denver, Colorado, and

Tom Cartee is a financial advisor and portfolio manager at Sheets Smith Wealth Management of Winston-Salem, North Carolina.

S&P DJI: How are you using municipal bond indices and the ETFs that track them to manage interest rate risk?

Matt: ETFs give us the flexibility to manage interest rate and credit risk in a more efficient manner than individual bonds do.  Over the past few years, it has become increasingly difficult to find bonds with the exposures we need to adjust our portfolios.  ETFs solve that problem.

Tom: The introduction of target maturity municipal bond ETFs means that investment advisors that prefer to use ladders as a way of managing interest rate risk may continue to do so.  Individual municipal bonds may be employed for certain rungs of the ladder, with target maturity ETFs positioned in the remaining rungs.

S&P DJI: Coming out of the global financial crisis, we saw many advisors wanting to decrease the duration of their fixed income exposure.  What are your thoughts now on duration for municipal bonds?

Tom: I doubt that rates will climb dramatically, but higher yields may be on the way.  As long as rate increases are gradual, short- and intermediate-term municipal bonds are not likely to disappoint market participants.  In the long run, a healthy economy and less Central Bank distortion could be good for financial markets.

Matt: Since the global financial crisis, we have chosen a somewhat longer duration than the index.  This duration decision was predicated on the idea that rates would remain lower for longer and the rolling crisis environment of the last few years has rewarded that posture.  We are now in the camp that we are nearing the end of falling rates, but feel that any rate increases will be moderate, and to that end we have moderated our duration accordingly.

SPDJI: Municipal bond laddering is a classic approach some advisors use to manage interest rate risk and reinvestment risk.  How have maturity series indices and ETFs enabled your ability to construct bond ladders?

Matt: We manage our municipal ETF portfolio as a modified ladder.  We ladder duration, but then weight our durations based on our valuation work.  ETFs also allow us to simultaneously create a barbell of credit exposure.  The ability to manage both duration and credit is a powerful combination that ETFs make possible.

Tom: I agree with Matt.  The maturity series municipal bond ETFs have been a welcomed addition to our fixed income toolkit.

My thanks to Matt and Tom for participating in this interview and in a recent webinar that is available now in our webinar archive on Including Bonds in Your Strong Core.