Indexology^® Blog

Right Now:  The economy is in better shape than what many incoming presidents face. GDP is growing, unemployment is 4.9% and inflation is about 1%. Interest rates are already rising with the 10 year treasury topping 2% yield and the Fed is signaling a December increase in the Fed funds rate.  US stocks are enjoying a turnaround in earnings and are responding positively.

What Next? The Press is comparing Donald Trump to Ronald Reagan. Both are Republicans from outside the party establishment, both plan big tax cuts and changes in economic policy.  Both are hailed as being in touch with voters. Reagan’s economic policy was tight money and increased federal spending. Combined with Paul Volcker’s inflation fighting at the Fed the economy emerged from a deep recession and grew. Stocks rose, interest rates fell as the bond market began a 30 year bull market.

Donald Trump’s approach to policy may be similar – he has said the Fed should raise rates and end its easy money approach; he wants to cut taxes and he speaks about a massive infrastructure spending program and increased defense spending

However, the economy today is not the economy of 1980. Inflation is about one percent today versus 13% on Election Day in 1980; yield on the ten year T-note is 2% now versus 12% in 1980; GDP was up 2.9% in the third quarter and the last recession ended seven years ago. In 1980 we were in a brief pause between two recessions and the one that lay ahead was second only to the Great Recession in severity.  There is at least one similarity: in 1980 and in 2016 there is a budget deficit which many people feared. Ronald Reagan promised to cut taxes, raise defense spending and balance the budget. He accomplished the first two – batting .667 may be a good score for a politician.

If Donald Trump follows a somewhat similar program, what might we expect?

• Interest rates are likely to rise – both the Fed and the President seem to be looking in that direction. But the rate increase is likely to be limited and the ten year Treasury note, now about 2%, will probably be 4% or less 18 months from now.
• Inflation should stay low. It has barely moved in a few years, expectations of future inflation, usually based on recent experience, are a key determinant of future inflation.
• Tax cuts are likely – Republican Congresses rarely raise taxes, although taxes did rise during the Reagan years.
• The stock market advance has further to go; it is supported by earnings, not politics, for the next six months.
• We will see a large infrastructure program. Almost as attractive to Congress as cutting taxes.
• The federal deficit will rise. Ronald Reagan preached supply side economics and the idea that cutting taxes would create so much growth that the budget would be balanced. It didn’t work then.

Donald Trump’s unexpected success initially threatened to send the U.S. equity markets into steep decline.  Yet as I write, the S&P 500 has moved very little since yesterday’s close (it is up a little), while the VIX has fallen dramatically.

So why (or how) has volatility remained so low this morning when everyone expected it to rise?  One reason may be that stock-level volatility has risen, but correlations have dramatically fallen.

A quick calculation using sector data suggests the higher dispersion in stock-level returns.  The chart shows the standard deviation among the 11 sectoral daily returns, So far today (as of 1pm EST) it is at the highest level this year.  There is volatility, but the winners are cancelling out the losers.

Higher dispersion – which was already rising in advance of the election, means a greater difference between winners and losers.  Today’s increase in dispersion – which may well prove temporary – is an indication of the degree to which Trump’s presidential victory, and continued Republican control of the Senate, were not appreciated by yesterday’s market consensus.

With anemic global economic growth, investors have become leery about U.S. companies’ ability to grow earnings and increase dividends.

Indeed, S&P 500 earnings declined for the fifth consecutive period in the second quarter of 2016 and even if the third quarter results are positive, the growth rate is likely to be very small. A potential consequence of this “earnings recession” is that future dividends could be at risk. Earnings are an essential driver of dividends, and ultimately returns, so there is good reason for concern.

But there’s an exclusive group of companies that may provide an answer. The S&P 500 Dividend Aristocrats^® Index includes high quality companies that have increased their dividends every year for at least 25 consecutive years. How are these companies able to continually grow dividends? One answer is by delivering earnings growth. The S&P 500 Dividend Aristocrats have delivered positive annual earnings growth for the first two quarters of 2016 in amounts that were substantially higher than the broad market.

Source: Morningstar, ProShares, May 2, 2005–June 30, 2016. Index performance is for illustrative purposes only and does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest in an index. Past performance does not guarantee future results.

The Take Away
Historically, the Dividend Aristocrats have grown their dividends on a more consistent basis and at a higher compound rate than the broad market, underscoring their quality and potential for strong performance. Since inception of the index, the Aristocrats have delivered higher returns with lower volatility than the S&P 500.

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