Indexology^® Blog

Why worry?  New highs for the U.S. stock market indices will keep coming, right?  Just in case, this might be a good time to examine asset classes that are not correlated to the equity market or the “uncorrelated”.

Corporate bonds of the issuers in the S&P 500 are tracked in the S&P 500 Bond Index.  As a group they have seen a negative correlation to the equities market.  Heavily composed of investment grade bonds the index has recorded a positive return of 0.65% year-to-date and a weighted average yield of 3.3%

Investment grade municipal bonds also historically have had negative correlations to the equities markets.  The S&P National AMT-Free Municipal Bond Index has recorded a 0.72% total return year-to-date.  These tax-exempt bonds have a weighted average yield of 2.31%.

Senior loans are higher in the capital market structure than unsecured high yield bonds and are also floating rate instruments.  These characteristics help make them less correlated with the equities market as well as the fixed rate bond markets.  The S&P/LSTA U.S. Leverage Loan 100 Index has recorded a positive return of 0.30% year-to-date.  The floating rate senior loans tracked in this index have a weighted average yield to maturity of 4.76%.

High yield or “junk” bonds tend to be more highly correlated to equities due the their position in the capital market structure.  As a result, junk bond and stock prices can at times move in the same direction based on the market’s perception of the companies strength or weakness.  With a weighted average yield of 5.85% the S&P U.S. High Yield Corporate Bond Index the index is up 1.57% compared to the S&P 500 Index which is up 3.66% (total return).

Table 1:  Select asset classes and their correlations to the S&P 500 Index:

If you buy a little extra chocolate this year for your Valentine, your wallet will be as happy as your sweetheart.  The S&P GSCI Cocoa is at its lowest level (closing Feb. 10, 2017) since Nov. 13, 2008.  It is down 31.3% since last year and is the single commodity with the biggest loss in the past 12 months.  

According to the International Cocoa Organization (ICCO), the cocoa prices decline was initiated from market expectations of a production surplus for the ongoing 2016/2017 cocoa season; mainly resulting from the prospects of a strong recovery in West African and Latin American production. Also, light rains mixed with hot weather and mild Harmattan winds in most of Ivory Coast’s main cocoa growing regions may boost next year’s crop according to farmers.

One thing to love about cocoa besides the fact that it is relatively cheap now, is that it is the commodity with the most favorable dollar movement ratio of commodities that lose from a rising dollar.  It has very little sensitivity to a rising dollar, losing on average just 6 basis points for every 1% rise in the dollar, yet it gains nearly 3.5% for every 1% the dollar falls.

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.