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Approaches to Achieving Low Volatility

Rieger Report: The Uncorrelated

Happy Valentine's Day: Cocoa Hits Lowest Since 2008

Under Armour Falters, but Consumer Discretionary Stays Positive

Index Basics: Calculating an Index’s Total Return

Approaches to Achieving Low Volatility

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Phillip Brzenk

Senior Director, Strategy Indices

S&P Dow Jones Indices

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Low volatility has been one of the most in vogue strategies during the past decade, with market participants still cognizant of the drawdowns that occurred during the financial crisis.  At S&P DJI, two of the most common strategies are applied to the S&P 500® universe to capture the low volatility anomaly—which is the observation that over the long term, less-volatile stocks have outperformed more-volatile stocks on a risk-adjusted basis.  Both the S&P 500 Low Volatility Index and the S&P 500 Minimum Volatility Index have historically taken advantage of this anomaly, but the portfolio construction approaches for these indices are quite different.  Exhibit 1 gives an overview of the methodology differences:

The S&P 500 Low Volatility Index employs a rankings-based approach, where stocks in the S&P 500 are sorted by the past one-year volatility of returns, and the 100 stocks with the lowest volatility are selected for index inclusion.  The index does not consider other constraints in portfolio construction (e.g., sector concentration or turnover) and instead simply selects the least volatile stocks.  The S&P 500 Minimum Volatility Index employs what could be considered a more sophisticated approach, using an optimizer and risk model to gain exposure to the price volatility factor, while also controlling for things such as unintended exposure to other factors, active sector weights versus the benchmark, and rebalance turnover.

A simple way to see that the two methodologies can lead to meaningfully different portfolios is to look at the constituent overlap, or how many stocks are constituents of both indices.  At year-end 2016, the S&P 500 Minimum Volatility Index had 96 constituents; just 44 of those were also constituents of the S&P 500 Low Volatility Index—less than a 50% overlap.  The differences in portfolio composition lead to deviations in sector composition, return attribution, and factor exposures, all of which are discussed in our recently released paper, Inside Low Volatility Indices.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Rieger Report: The Uncorrelated

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J.R. Rieger

Head of Fixed Income Indices

S&P Dow Jones Indices

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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:

Source: S&P Dow Jones Indices, LLC. Data as of February 10, 2017. Table is provided for illustrative purposes. It is not possible to invest directly in an index. Past performance is no guarantee of future results.

 

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Happy Valentine's Day: Cocoa Hits Lowest Since 2008

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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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.  

Source: S&P Dow Jones Indices

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.

Source: S&P Dow Jones Indices.

 

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Under Armour Falters, but Consumer Discretionary Stays Positive

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Kevin Horan

Director, Fixed Income Indices

S&P Dow Jones Indices

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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).

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Index Basics: Calculating an Index’s Total Return

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Reid Steadman

Managing Director, Global Head of ESG

S&P Dow Jones Indices

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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.

Formula 1 Total Return Post

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.

Formula 2 Total Return Post

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.

Formula 3 Total Return Post

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®.

Total_Returns_Ex1 Total_Returns_Ex2

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 posts on this blog are opinions, not advice. Please read our Disclaimers.