Indexology^® Blog

The sports apparel and footwear company Under Armour recently experienced a highly publicized loss of stock value, based on a couple of missteps.  The first misstep was falling short of Wall Street’s earning expectations, which caused multiple brokerage firms to downgrade their stock recommendations.  The second was inaccurate forecasting of the company’s revenue; it only rose by 12%, while the management team had been projecting a 22% increase.  The final misstep was the resignation of the company’s CFO.  Though personal reasons were stated for this, the perception of the change and its timing has turned a concerned eye on the management situation.

Though the current news was unsettling for equities, Under Armour’s debt consists of one bond (USD 600 million at 3.25%, issued on June 15, 2016), which is a component of the S&P 500^® Bond Index (0.013%).  Underneath the S&P 500 Bond Index are two subindices, as the debt in the index is divided into investment grade and high yield.  As of Feb. 9, 2017, Under Armour holds a 0.014% weight in the S&P 500 Investment Grade Corporate Bond Index, and the apparel, accessories & luxury goods industry subsector consists of a 0.08% weight.  The bond has been included among other apparel issuers, such as Coach, Ralph Lauren, and VF Corporation.

In response to the most recent events, the Under Armour bond has been downgraded to BB+ and will be moved out of the investment-grade index and into the S&P 500 High Yield Corporate Bond Index at the next month-end rebalancing (February 2017), as per the index rules.  It will leave behind its investment-grade apparel group to join the high-yield apparel issues of Hanesbrands and PVH Corp., which have a weight of 0.59% as of Feb. 9, 2017, but will increase to 0.72% with the inclusion of Under Armour.

For now, this appears to be an isolated event, as the total return of the consumer discretionary sector, of which apparel, accessories & luxury goods is a component, has continued to provide consistent positive returns (see Exhibit 1).

Total return indices deserve more attention.  They more closely represent what an investor actually takes home: the return of an index, plus dividends paid and reinvested in the index.  Their better-known counterparts, which only track price changes in securities—often called “price return indices”¹—get all the fanfare (see “Dow Hits 20,000 for the First Time”).  Total return indices, on the other hand, are often quietly downloaded and placed in a chart halfway through a financial advisor’s presentation.

Though I doubt people will ever stop looking at price return indices first, a step in the right direction is for investors to develop a better understanding of how total return indices work so they will use them more often.

How Total Return Indices Are Calculated

The aim of a total return index is to reflect the full benefit of holding an index’s constituents over a given time.  This means reinvesting dividends into the index by adding them, period by period, to the price changes of the index portfolio.  But how do you add dividends—which are valued in dollars, euros, and other currencies—to an index, which is expressed in points?

The trick is one you learned in fifth grade, to establish a common denominator.  This is done by dividing the dividends paid over a period by the same divisor used to calculate the index.  This gives you “dividends paid out per index point.”  The equation is as follows.

The next step is to adjust the price return index value for the day, not the total return index, using the following formula, which combines the dividends and index price change.

Finally, to apply this adjustment to the total return index series, which accounts for a full history of dividend payments, this value is multiplied by the previous day’s total return index level.

Again, the process is to (1) find the dividends per index point, (2) adjust the price return index, and then (3) apply this adjustment to the previous day’s total return index value.

The Power of the Total Return

Market participants often underestimate the power of dividends.  Exhibits 1 and 2 show the price and total return indices for the S&P 500^® and the Dow Jones Industrial Average^®.

These charts show five years of index values, ending in January 2017.  By the end of this period, the total return indices for the Dow Jones Industrial Average and S&P 500 were ahead of their price return counterparts by 13.5% and 11.3%, respectively.

The next time an index—likely a price return index—hits a major milestone and is noted in the media, take the time to go to the S&P Dow Jones Indices website to see how the total return version of this same index performed.  With dividends included, the index will have done even better than journalists and the talking heads on television are acknowledging.

¹   “Price return indices” should not be confused with “price-weighted indices.”  In price-weighted indices, the most famous of which is the Dow Jones Industrial Average, components are assigned weights according to the level of their individual prices.  A “price return index” is any index with any weighting scheme that only accounts for price changes in the underlying securities.  The DJIA is a price return index and a price-weighted index.  The S&P 500 is a price return index, but market-cap weighted, not price weighted.

The past few months have served as a timely example of why it is beneficial for real estate to stand alone as its own equity sector.

Between Sept. 16, 2016, when real estate was carved out of financials as its own GICS sector, and the end of January 2017, the S&P 500^® Financials gained 22%, leading all 11 sectors.  Meanwhile, the S&P 500 Real Estate declined 2%—the worst-performing sector (see Exhibit 1).

Exhibit 1: Financials Sector Has Vastly Outperformed Real Estate Since the GICS Structure Change

Why has this happened?   In short, financials has been buoyed by prospects for higher interest rates and expectations of reduced regulation from the new Trump administration.  On the other hand, rising interest rates have weighed on the real estate sector, which had benefited from the low interest rate environment of the past several years.  This divergence is not all that surprising given the fundamental differences between real estate and financials businesses and the macroeconomic drivers that affect these industries.

The recent separation of real estate from financials facilitates greater transparency into sector performance trends and allows market participants to have greater precision in asset allocation decisions.  The past few months have been a clear sign of why it was time for a change.

What a year 2016 was—from concerns about slowing down of the Chinese economy and a surprise vote by the UK to exit the EU to a continued trend of low-to-negative interest rates among major economies globally, demonetization in India, the shocking victory of Donald Trump in the U.S. presidential election, and finally, the U.S. Federal Reserve ending the year with a hike of 25 bps in short-term interest rates. Throughout the year, market participants kept asking “what next?”

While global markets, as measured by the S&P Global BMI, were up 8.84% for the year, if U.S. equities’ 12.61% return is excluded, the gain was 4.95%.  The S&P Developed BMI and S&P Emerging BMI posted positive total returns of 8.6% and 11.30%, respectively.

Backed by a rally in crude oil and metal prices globally, the S&P GSCI (the first major investable commodity index) gained 11.37% in 2016.

Indian Equities

Despite various negative events, Indian equities gained in 2016.  Backed by a normal monsoon, low inflation, falling key lending rates, an under-control fiscal deficit, and a relatively stable currency, India’s bellwether index, the S&P BSE SENSEX, and the S&P BSE AllCap (India’s benchmark index) ended the year with total returns of 3.5% and 5.1%, respectively.  The majority of their gains for the year were achieved during the second and third quarters, as most of the key benchmark indices ended positive during those two quarters (see Exhibit 1).

The S&P BSE MidCap was the best-performing size index, with a total return of 9.3%, while the S&P BSE SmallCap continued to be worst-performing size index, with a total return of 2.7% in 2016.

Among key BSE sector indices, the S&P BSE Basic Materials posted the highest total return for the year, with 33.5%, due to increase in global commodity prices.  A cash crunch caused by demonetization hurt the S&P BSE Consumer Discretionary Goods & Services the most, as during Q4 2016 it posted the worst total return of -9.9%.  2016 was one of the worst years for the S&P BSE Telecom since the financial crisis, with a total return of -20.9%.

Indian Fixed Income

Compared to calendar year 2015, Indian bond market posted higher returns in 2016 due to falling interest rates. The S&P BSE India Government Bond Index and the S&P BSE India Corporate Bond Index posted positive returns of 13.5% and 11.1%, respectively.  The S&P BSE India 10 Year Sovereign Bond Index posted an impressive total return of 14.2%, outperforming the S&P BSE SENSEX by more than 10.7% in 2016.

Outlook

Among other things, market participants may want to keep an eye on the upcoming budget, the Goods and Services Tax implementation, the Reserve Bank of India’s view of future interest rate movements and inflation, global commodity prices, and the U.S. Federal Reserve’s potential decision to further increase interest rates.  Although demonetization is expected to have a short-term negative impact on the GDP growth rate, it is expected to help expand the formal economy, due to a push for digitization.

U.S. home prices hit a new record high as measured by the S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index setting an all-time high in three consecutive months (with data ending in Nov.) It’s not the only indicator showing signs of growth and inflation as U.S. consumer spending accelerated in December as households bought motor vehicles and cold weather boosted demand for utilities amid a rise in wages, pointing to sustained domestic demand that could spur economic growth in early 2017.

January was an eventful month with President Trump’s inauguration, and with his new administration promising to cut taxes, it could accelerate consumer spending. Although Trump’s economic policy is still unfolding, consumer confidence has surged and commodities ex-energy are having their strongest start since 2012, up 4.4% in Jan., the 9th strongest in history since 1970.

However, energy, the worst performing sector in Jan., detracted from both the S&P GSCI Total Return and DJCI (Dow Jones Commodity Index). Energy lost 4.7% in the S&P GSCI Total Return for an overall monthly loss of 1.4%, while energy lost 5.1% in the DJCI limiting its gain to 0.7% in Jan. The bigger energy sector loss in the DJCI comes from its heavier liquidity-based weight to natural gas, the worst performing commodity in Jan. with a total return loss of 16.1%, but the greater energy sector impact on the S&P GSCI is attributed to the heavier weight in the sector from the index’s world-production weight.

Two forces weighing on petroleum now are production decisions from OPEC and the U.S., and the tax policy that will potentially create a disparity between incentives of producers and processors by encouraging producers to export, but processors to buy domestically.  If this promotes more domestic oil production, holding WTI crude oil will likely continue to be more expensive than holding brent.  Jan. marked the second consecutive month the negative roll yield on WTI was bigger than for brent, diluting an extra 62 basis points for the month – after losing an extra 67 basis points last month for the biggest combined loss since Aug.-Sep. 2016.  If this U.S. production continues to rise, it could take another 2 years to reach equilibrium before setting a record long stretch of contango.  Additionally, the gas price will need to rise more (from the tax) than the oil prices falls in order to keep inflation up.  In Jan. unleaded gasoline lost about 5.5% more than oil, which is pretty significant, but once the tax kicks in, that might change.

Despite losses in all 6 commodities in the energy sector, 13 of 24 commodities were still positive in Jan.  Livestock was the other losing sector, down 1.1% for the month. Agriculture and precious metals gained 3.5% and 5.5%, respectively for the month.  Industrial metals gained 5.4%, making it the best performing sector in Jan.

It’s difficult to attribute any commodity performance to Trump yet since he only took office on Jan 20, but it looks like oil fundamentals are holding based on production while aggregate demand hopes are driving industrial metals.  The S&P GSCI Industrial Metals average rolling correlation is increasing significantly since the election with the average rolling 30-day correlation rising to 0.60 from 0.37 while the 90-day that is smoother is rising from 0.38 to 0.50.

While industrial metals are sensitive to their unique supply issues, the higher correlation does show strength from aggregate demand.  4/5 industrial metals were positive in Jan. (nickel slightly lost,) which shows strength. Historically, this many industrial metals only rise together about 1/3 of the time, and all 5 rise together only about 1/5 times.

Inside the S&P GSCI Industrial Metals Total Return sector, lead performed particularly well gaining 17.9%, delivering its best month since July 2010 and 11th best ever on record (since Jan. 1995.)

Last, the weaker dollar from the year’s beginning may have also significantly boosted industrial metals, especially lead, that typically gains most from a weaker dollar, gaining on average over 7% for every 1% the dollar falls.