Indexology^® Blog

One of the objectives of low volatility strategies is to provide higher risk-adjusted returns than their respective benchmarks over the long run, primarily by reducing drawdowns during market downturns.  In the U.S. market, both the S&P 500^® Low Volatility Index and the S&P 500 Minimum Volatility Index have shown outperformance over the S&P 500, not just on a risk-adjusted basis, but also in absolute terms (see Exhibit 4 of Inside Low Volatility Indices).  To understand how the volatility strategies performed in the most significant down markets, we look at the three largest drawdowns of the S&P 500 since 1990:

In all three drawdown periods, the low-risk strategies outperformed the benchmark.  In the financial crisis (2007-2009), the S&P 500 Low Volatility Index outperformed the S&P 500 by over 15% and the S&P 500 Minimum Volatility Index outperformed by more than 6%.  The return differential during the tech bust (2000-2002) was more extreme, with the minimum volatility outperforming by 30% and the low volatility index outperforming by 50%.  During the Russian currency crisis (1998), the S&P 500 dropped 19% in under two months, and the low-risk strategies were again able to limit losses.

Did the low-risk indices outperform during the market downturns for the same reasons, or did the methodology differences (as outlined in a previous post) lead to different sources of excess return?  A common approach to analyzing this is to run a sector-based performance attribution, which breaks down the total excess return of a portfolio versus a benchmark between an allocation effect and a selection (+ interaction) effect.  The allocation effect will show the effect of over- or underweighting a sector relative to a benchmark, while the selection effect will show the effect of over- or underweighting individual securities within a sector relative to the benchmark.  The sector-based attribution results for the low-risk strategies during each of the three largest drawdowns of the S&P 500 are shown in the following exhibits, with the sector that had the highest total effect highlighted for each index.

During the largest drawdown, the financials sector was the largest contributor to excess return for both volatility strategies, with a total effect of 3.91% in the S&P 500 Minimum Volatility Index and 7.04% in the S&P 500 Low Volatility Index.  While both outperformed, the allocation and selection effect figures show contrasting reasons for the outperformance.  In the minimum volatility index, the allocation effect for financials was negative (-1.50%), as the financials sector in the S&P 500 underperformed, and the minimum volatility index had an average sector weight higher than the benchmark.  However, it was successful in selecting or weighting securities within the sector (selection effect of 5.41).  In the low volatility index, the financials sector’s weight was significantly reduced during the period, with an average weight of 9.23% lower than the S&P 500.  The underweight led to an allocation effect of 4.86%, while the selection effect contributed 2.17%.

The second-largest drawdown (tech bust) highlights the methodological differences for sector diversification.  Both low volatility strategies allocated away from information technology, but the minimum volatility index sector constraints (±5% relative to the benchmark at rebalancing), whereas the low volatility index can move completely out of a sector.  This occurred for the information technology sector in the low volatility index, which lead to a total effect of 18.39%.

What is evident in examining the drawdown periods is that the majority of outperformance can come from different effects for the two low-risk indices.  The selection + interaction effects drove most of the outperformance for the minimum volatility index, while the allocation effect drove the majority of the outperformance for the low volatility index.

Our related research paper, Inside Low Volatility Indices, expands on the comparison between the two low-risk strategies.

March 22, 2017, is World Water Day, the U.N.’s annual bid to raise awareness about the water crisis.  Climate change, pollution, and overconsumption are making fresh water an increasingly scarce resource.  Worldwide, 663 million people currently have no access to clean water.  By 2030, it is predicted that there will be a 40% shortfall in water supplies.[1]

Good quality water is essential to the production of nearly everything, from the food we eat to the clothes we wear.  Trucost research found that in 2016, listed companies reported exposure to water risks totaling almost USD 126 billion, due to higher operating costs associated with declining water quality and water supply disruption.  However, when taking into account the thousands of listed companies that do not disclose on water dependency, the risk could be up to USD 439 billion.

The main problem is the lack of an appropriate market price for water—one that reflects its full economic, social, and environmental value.  In most regions, there is little correlation between the price paid for water and its availability or quality.  In many places, water is cheapest where it is most scarce.  Weak regulation means water basins can be polluted by effluent discharges.

As good quality water gets scarcer, companies become increasingly exposed to water-related risks.  Market participants are also exposed to these risks through equity holdings, corporate loans, and project finance in water-intensive sectors.

Analysis by Trucost shows that if the full costs of water scarcity and pollution had to be absorbed by companies as a result of reduced water allocations, higher conditioning costs, or tougher effluent discharge requirements, average profits could fall by 18% in the chemical sector, 44% in the utilities sectors, and a massive 116% in the food and beverage sector (see Exhibit 1).

To understand and manage these risks, companies need better data on where water risks are in their global operations.  Analytical tools, such as Aqueduct by the World Resources Institute,[2] provide a way to screen locations where water is scarce.

Ecolab’s Water Risk Monetizer[3]—powered by Trucost and Microsoft—extends the insights from the Aqueduct tool and puts a monetary value on water risks, including scarcity and quality, so that they can be factored alongside operational costs and revenue forecasts.  The Water Risk Monetizer also allows users to calculate asset-level avoided risk and return on investment of water improvement projects, illustrating how businesses should prioritize investments, engage with other water users, and monitor local water conditions.

Market participants can manage risk by encouraging better corporate disclosure of water-related financial risks.  This was recognized in draft recommendations published by the Financial Stability Board’s Task Force on Climate-related Disclosures[4] in December 2016, which said that all organizations, from companies to financial institutions, should disclose information on their governance, strategy, risk management, metrics, and targets for managing climate risks, including water scarcity.  Enhanced disclosure on water will accelerate mainstream green finance as more relevant information reaches the market.

The first step is for companies and market participants to understand the water risk exposure of operations, suppliers, assets, and investments so they can build resilience against increasing water scarcity and pollution impacts, identify opportunities from water stewardship solutions, and engage with stakeholders to drive change through the market.

[1]   http://unesdoc.unesco.org/images/0023/002318/231823E.pdf

[2]   http://www.wri.org/our-work/project/aqueduct

[3]   http://waterriskmonetizer.com/

[4]   https://www.fsb-tcfd.org/publications/recommendations-report/

For many plan participants, the goal of a retirement account is to provide a steady stream of income that will sustain their standard of living in retirement. Therefore, participants need a framework that aligns the management of their savings with their retirement income goal. This framework has three related components:

1. Risk management that addresses the risks that are relevant to retirement income.
2. Asset allocation that balances the tradeoff between asset growth and income risk management.
3. Meaningful communication that enables participants to monitor performance in income units.

Risk Management
The first consideration regarding risk management is how long you expect participants’ accumulated savings to support their consumption in retirement. In the US, the average life expectancy of a 65-year-old person is 85 years.[1] To account for uncertainty about life expectancy, we can add a five-year buffer to the average retirement horizon, resulting in a 25-year expected withdrawal period.

The next step is to identify the key drivers of income uncertainty over that withdrawal period. Retirement income uncertainty is driven by market risk (uncertainty of future stock and bond returns), interest rate risk, and inflation risk. These risks can be reduced by computing the duration of the retirement income stream and allocating to a portfolio of inflation-protected securities that are duration-matched to the planned retirement horizon. This is the basis of the risk management strategy of Dimensional’s retirement solutions and the S&P Shift to Retirement Income and Decumulation (STRIDE) Index Series. This framework also helps to manage sequencing risk, as the level of retirement income that can be supported by the allocation to risk management assets is not very sensitive to market risk, interest rate risk, or inflation risk.

Asset Allocation
Having identified an appropriate risk management strategy, the asset allocation question then becomes a tradeoff between allocating to growth assets vs. risk management assets. The higher the allocation to risk management assets, the lower the expected volatility of retirement income. In launching the S&P STRIDE Indices, S&P Dow Jones Indices has developed a benchmark for investment solutions that seek to grow the value of participants’ savings while managing retirement income uncertainty. This entails a focus on asset growth early in participants’ lifecycles with a transition to an income-focused strategy over time. As participants transition into retirement, the majority of their assets are invested in inflation-protected government securities matched to their retirement horizon. This liquid investment strategy can be used by participants who desire periodic withdrawals in retirement.

Meaningful Communication
A retirement solution should also allow participants (and their plan sponsors) to monitor progress toward a retirement income goal. This can be achieved through information that translates the purchasing power of participants’ account balances in terms of estimated retirement income. The S&P STRIDE Indices include a monthly cost of retirement income called the Generalized Retirement Income Liability (GRIL)[2] for each retirement cohort, which can be used to translate account balances to estimated retirement income.

If the GRIL goes up (down), generating a given level of income becomes more (less) costly, and the purchasing power of a given level of savings goes down (up). Because of the risk management framework in the S&P STRIDE Indices, uncertainty about participants’ future income is reduced over time so that communication in income units can be more meaningful. We believe the right risk management helps provide clarity about expected retirement outcomes and empowers participants to make better retirement decisions.

[1] Source: Social Security Administration: Calculators – Life Expectancy. The age of 85 is computed by averaging the male life expectancy and the female life expectancy for people turning 65 in 2017.

[2] GRIL is defined as the present value of $1 of annual inflation-adjusted income over 25 years starting at the target date. The interest rates used to discount these future hypothetical cash flows to the present are derived from the current US TIPS curve.

The S&P STRIDE INDEX is a product of S&P Dow Jones Indices LLC or its affiliates (“SPDJI”) and has been licensed for use by Dimensional Fund Advisors LP (“Dimensional”). Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); these trademarks have been licensed for use by SPDJI and sublicensed for certain purposes by Dimensional. Dimensional’s Products, as defined by Dimensional from time to time, are not sponsored, endorsed, sold, or promoted by SPDJI, S&P, Dow Jones, or their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such products nor do they have any liability for any errors, omissions, or interruptions of the S&P STRIDE Index.

Dimensional Fund Advisors LP receives compensation from S&P Dow Jones Indices in connection with licensing rights to the S&P STRIDE Indices. It is not possible to invest in an index.

Assets are shifting from active to passive: “investors pulled $23 billion out of actively managed U.S. equity funds, extending the group’s streak of outflows to 33 consecutive months.  During 2016, passive fund strategies in the United States took in a record $504.8 billion.”[1]  In response to this, an elegant point has been made “that the average investment manager does not outpace the market over meaningful time horizons.  However, a fairly simple fact has gotten lost in the debate.  Simply put, not all investment managers are average”[2] and that the way to find these managers is by screening for low-cost active funds and managers who are participating in the funds they run.  Thus an active approach can add value by beating its benchmark when costs are reasonable and the manager’s incentives are aligned with fund those of the fund’s participants.

You Forgot About My Taxes!

Understanding that past performance does not guarantee future results, it is possible that one day active management may prove its value beyond a select population of low-cost and self-invested fund managers.  However, “passive management, as many studies have demonstrated, almost always wins out in the long term—both because it’s inherently more tax effective and because it’s less costly,”[3] and while not every active manager is average and many do offer low cost solutions, the impact of taxes is another factor that must be considered in the analysis. It’s important to note “on an after-tax basis, managers of stock funds for large- and mid-sized companies produced lower returns than their index-style competitors 97% of the time, while managers of small-cap stocks trailed 77% of the time.”[4]  Furthermore, “taxes knocked an average of 0.96 percentage point a year off the returns of about 2,000 actively managed U.S. stock mutual funds over the 15 years ended in September 2014, if they were held in taxable accounts rather than tax-sheltered retirement plans, according to research by Vanguard Group. By contrast, taxes reduced the returns of 130 broad-based U.S. stock index funds by an average of 0.69 percentage point a year over the same period—about one third less.”[5]

You Can’t Keep Going!

Financial advisor Steven Lockshin reviewed S&P DJI’s December 2016  Persistence Scorecard as it pertains to active management and noted that:

• Relatively few funds can stay at the top. Out of 631 domestic equity funds that were in the top quartile as of September 2014, only 2.85% managed to stay in the top quartile at the end of September 2016.  Furthermore, 2.46% of the large-cap funds, 2.20% of the mid-cap funds, and 3.36% of the small-cap funds remained in the top quartile;
• The figures are equally unfavorable when viewed over longer-term investment horizons. Over the five-year period, 91.91% of large-cap managers, 87.87% of mid-cap managers, and 97.58% of small-cap managers lagged their respective benchmarks;
• Similarly, over the 10-year investment horizon, 85.36% of large-cap managers, 91.27% of mid-cap managers, and 90.75% of small-cap managers failed to outperform on a relative basis.[6]

This is important because when one participates in an active mutual fund, the statistical odds of continued outperformance against the benchmark are not high.  When taxes are factored into the analysis, the picture arguably becomes more compelling for the use of passive strategies.

Taxes Are Not Just an Issue for Active Mutual Funds

Beyond the tax issue for active mutual funds, “taxpayers should beware that as IRAs increase in size, so does the potential for taxes on these accounts if they have investments in alternative assets such as hedge funds, private-equity funds, limited partnership, operating businesses and real-estate.”[7]  So if hedge funds or private equity funds seem appealing, just remember their tax costs could be significant, even in an IRA.

The Bottom Line

The bottom line when considering active versus passive investing is if the performance of an active strategy does not get you, the taxes might.

[1]   https://corporate.morningstar.com/US/documents/AssetFlows/AssetFlowsJan2017.pdf

[2]   https://www.americanfunds.com/individual/insights/active-management/adding-our-voice-indexing.html

[3]   Steven Lockshin, http://www.iris.xyz/network/active-investments-lot-hope-dangerous

[4]“             Active vs. Passive Investing: Which Approach Offers Better Returns?” http://executiveeducation.wharton.upenn.edu/thought-leadership/wharton-wealth-management-initiative/wmi-thought-leadership/active-vs-passive-investing-which-approach-offers-better-returns

[5]   Laura Saunders, https://www.wsj.com/articles/how-passive-funds-trim-your-tax-bill-1476968401

[6]   Steven Lockshin, http://www.iris.xyz/network/active-investments-lot-hope-dangerous

[7] Laura Saunders, https://www.wsj.com/articles/are-taxes-lurking-in-your-tax-free-retirement-account-1489141814

When people think of a low-carbon economy, the U.S. may not be the first one to come to mind.  In almost all things ESG, Europe is considered the leader.  However, the U.S. market has made some strides in recent years.  The carbon footprint of the S&P 500^® has actually been declining since 2011, as illustrated in Exhibit 1.

This is good news for ESG market participants, although this decline has also started to stagnate, signaling that the low-carbon economy in the U.S. is at a critical point, with two possible outcomes.

On one hand, the head of the Environmental Protection Agency (EPA) recently questioned the role of carbon dioxide as a harmful pollutant—portending the potential future policy changes by the EPA.[1]  To put this in to context, back in 2007, the Supreme Court ruled that carbon dioxide was an air pollutant and that under the Clean Air Act, the EPA was all but required to regulate carbon dioxide, unless they were able to provide scientific evidence that greenhouse gases (GHGs) were not harmful.[2]  The recent statement questioning the link between carbon and climate change makes it look like the EPA may be leaning toward the latter part, and therefore attempting to deregulate the carbon economies—a concern for those focused on socially responsible investing.

On the other hand, while the change in EPA policy may be disheartening, it’s clear that the global markets feel differently.  This new stance signals a widely different viewpoint than most other countries around the globe.  In November 2016, delegates from 197 countries met in Marrakesh for COP 22, an annual climate change conference designed to reduce the production of GHGs.  This was a follow up to COP 21 in 2015, where these same countries (including the U.S.) met and signed the Paris Agreement, with the goal of preventing global temperatures from rising more than 2˚C above pre-industrial times.

In addition, market participant interest is increasingly focused on low carbon, particularly as those indices outperform the benchmark.  As illustrated by Exhibit 2, the S&P 500 Carbon Efficient Index and the S&P 500 Carbon Efficient Select Index have continued to outperform the benchmark (ever so slightly).

While public policy may no longer be implementing environmental regulation, market participant interest may be the driving force behind carbon reductions in the U.S.  We can expect that the world will continue to try to offset the damage done by GHGs—regardless of policy in the U.S.—and these efforts are likely to continue to affect financial markets, where interest in ESG investing continues to grow.

[1] http://www.reuters.com/article/us-usa-epa-pruitt-idUSKBN16G1XX

[2] http://www.nytimes.com/2007/04/03/washington/03scotus.html