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Security Selection & Sector Allocation Effects of Equal Weighting the S&P 500®

The Wrong Diagnosis

The Lifetime Income Disclosure Act of 2017

Commodity Trends Boost Leveraged and Inverse Indices

The Little Cousin to TIPS

Security Selection & Sector Allocation Effects of Equal Weighting the S&P 500®

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Philip Murphy

Managing Director, Global Head of Index Governance

S&P Dow Jones Indices

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Constituents of the S&P 500 Equal Weight (EW) and S&P 500 are identical, but the EW version is rebalanced quarterly so that every company has equal representation after the rebalance.  That often results in significantly different performance between the two indices, because equal weighting gives more representation to smaller stocks and alters the distribution of sector exposure.

Sector representation is different between the indices because the weight of a sector in the EW index is strictly a function of the number of stocks in the sector, whereas cap-weighted sectors depend on company size and company count.  The largest sector in the EW index is consumer discretionary, because it has the most companies (85 as of March 31, 2017); however the largest deviation from cap-weighted sectors is in information technology because that sector comprises several mega-cap companies such as Apple, Alphabet (parent of Google), Microsoft, and Facebook.  Exhibit 1 shows relative sector weights of the EW index versus its cap-weighted benchmark.

In the 14 years since its launch on Jan. 8, 2003 (counting 2003 as a full year), the S&P 500 EW outperformed the cap-weighted S&P 500 10 times, underperforming in 2007, 2008, 2011, and 2015.  The magnitude of outperformance was greatest in 2009 as the market bottomed and then began its recovery from the global financial crisis.

Decomposing performance of the S&P 500 EW relative to the S&P 500, using 2 Factor Brinson Attribution (showing sector allocation and security selection effects) illustrates the historical impact of EW variation relative to the cap-weighted benchmark.  Since the set of index constituents are identical, the security selection factor measures only the effect of weight differences between the indices.

In spite of significantly different sector allocations between equal- and cap-weighted indices, most of the value added or detracted by equal weighting comes from variations of individual component weights.  In other words, the effect of EW security selection has historically dominated that of EW sector allocation.  The value of security selection relative to sector allocation is important because it demonstrates that the S&P 500 EW aligns with a desire to gain access to smaller S&P 500 stocks without necessarily resulting in detraction from sector redistribution.  Market participants looking for a simple variation of cap-weighting with a reasonable chance of adding value over time may want to consider investment strategies tracking S&P 500 EW.

[1] GICS stands for Global Industry Classification Standard.  Information about GICS is available at http://spindices.com/resource-center/index-policies/.

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

The Wrong Diagnosis

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Craig Lazzara

Managing Director and Global Head of Index Investment Strategy

S&P Dow Jones Indices

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This morning’s Wall Street Journal described how “a $1.4 billion ETF gold rush” supposedly has disturbed the pricing of mining stocks around the world.  $1.4 billion turns out to be the incremental cash flow into a single exchange-traded fund designed to track an index of the gold mining industry, including some relatively small-capitalization companies.  These flows, it is argued, are another illustration of how passive management is disrupting market efficiency and creating a bubble, the economic effects of which some commentators consider to be even worse than Marxism.

I have no opinion on whether there is a bubble in gold shares at the moment; having one would require a knowledge of these stocks’ fundamental valuations relative to their market prices.   But the bubble, if there is one, has nothing to do with passive management and is only tangentially related to the ETF in question.  The bubble, if there is one, is being inflated by investors who’ve decided that they want to increase their exposure to gold.

If you doubt this, consider what would happen if no ETFs invested in gold stocks, but actively-managed mutual funds did.  Then presumably the $1.4 billion that flowed into the gold ETF would have gone into an actively-managed fund.  An active portfolio would almost certainly be less diversified than the ETF, which means that the same asset flows would have been directed to a smaller number of stocks where they would presumably have been even more disruptive.

When the technology bubble inflated in the late 1990s, the ETF industry was a negligible fraction of its current size.  Bubbles inflate with greed and deflate with fear; whether the mechanism by which fear and greed are expressed is active or passive is a secondary issue.  Focusing on an ETF rather than on the motives of its purchasers is the wrong diagnosis.

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

The Lifetime Income Disclosure Act of 2017

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Peter Tsui

Director, Global Research & Design

S&P Dow Jones Indices

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Earlier this month, both the Senate and the House introduced bipartisan legislation to amend the Employee Retirement Income Security Act that would mandate annual income disclosures on 401(k) and other defined contribution account documents.  The language in the legislation is identical to a bill introduced in 2009, early in the Obama administration.  This new effort reflects the ongoing concern that Americans are lagging significantly behind in their retirement savings.  At a minimum, the logic behind the proposed legislation is that estimates of plan participants’ future retirement income may motivate them to pay closer attention to savings rates and may encourage more aggressive deferrals to make up for savings shortfalls as evidenced by the income estimates.

However, despite the good intention, there are significant hurdles in coming up with an easy-to-understand and implementable methodology.  For the lifetime retirement income estimate to be useful, it has to be realistic, and that means quite a few assumptions have to be made, including the savings rate, investment returns, and stability in job tenure.  Besides, it is one thing to estimate the retirement income for a 65-year-old with close-to-retirement account balances, but it is something else to estimate the same thing for a 35-year-old, 30 years away from retirement.

For participants who are close to retirement, a standard, simple income calculation based on a participant’s current account balance using today’s rates in the immediate annuity market would be an easy and acceptable way to provide the income estimate.  For a younger participant with a much lower balance, using the same approach, without taking into account the anticipated future savings, would clearly result in a much lower income estimate and may or may not be helpful to the younger participant.  Thus, we may want to allow plan sponsors to provide different types of income estimates based on the participants’ proximity to retirement.

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

Commodity Trends Boost Leveraged and Inverse Indices

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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In the context of declining commodity prices following the global financial crisis, inverse indices became popular for market participants looking to profit from negative returns. As the oil war unfolded and drove commodity prices further down, market participants took a renewed interest in using inverse indices to bet against the market. When commodities rebounded last year, market participants remained opportunistic, demanding leveraged indices for the potential to earn extra in the comeback by doubling down. However, there have been some questions and observations about the performance of inverse and leveraged indices as their popularity has increased.

Why is the performance of the inverse indices not exactly opposite from the standard, long-only versions?  The inverse performance is exactly opposite the standard, long-only indices, but only for the stated period. For example, most of the inverse indices have a daily rebalance, which means the daily return of the inverse excess return index will be opposite from the standard excess return. However, when these returns are compounded, a performance difference arises that is beneficial in trending markets. Exhibit 1 shows a simple example of the performance impact of two daily consecutive positive moves and two daily consecutive negative moves. Note that there is an arbitrage opportunity for market participants if they pursue both strategies during trending times; when there are two consecutive negative moves, the inverse index gains more than the standard index loses, and if there are two consecutive positive moves, the standard index gains more than the inverse index loses. The magnitude of the consecutive losses and gains does not matter for this relationship to hold.What happens to the cumulative returns when the daily returns move in opposite directions?  In this case, the magnitude of the returns matters, but not the order. If a market participant were to pursue both strategies, it would likely be a losing proposition in a choppy market. The only way to profit is by picking whether the larger absolute return will be positive or negative and using the standard long index for the larger absolute positive return and the inverse index, which is like a short position, for the larger absolute negative return. If the magnitudes of the opposite consecutive returns are the same, the directional order makes no difference, as shown in the first column of Exhibit 2, and there is a certain loss for both the standard and inverse indices. However, there is a chance to win if opting for only one strategy with a correct bet on the bigger absolute return, regardless of order.What conclusions can be drawn for 2x leveraged indices when daily returns are compounded?  Similar results are observed when comparing the standard indices to the 2x leveraged indices, which double the daily return. The compounded returns when there are two days of consecutive losses or gains show that the 2x leveraged version has a better payoff profile, since it loses less than double the standard index return but gains more than double. If a market participant is sure about commodity trends over time, then the 2x leveraged index may be a winning bet, even if the direction is uncertain.

However, if the daily returns move in opposite directions, then the magnitude matters. For returns of the same magnitude moving in opposite directions, the 2x leveraged version magnifies the loss by more than a factor of two, as shown in Exhibit 3. Also, the gain in the 2x leveraged index is less than double when the magnitude of the positive return is larger than the magnitude of the negative return, while the loss is more than double when the magnitude of the negative return is bigger than the magnitude of the positive return. Again, unless a market participant picks the direction of the big move, the standard index may be the better choice in a choppy market.Are there some commodities that trend more than others, and might be advantageous in a 2x leveraged or inverse version?  The most popular commodities used in 2x leveraged and inverse indices for products are Brent crude, copper, corn, WTI crude oil, gold, natural gas, silver, and soybeans.

From Jan. 2, 2007, to March 24, 2017, each of these commodities trended nearly 50% of the time. Corn trended the most, exactly 50% of the time, while copper and silver trended the least, around 46% of the time. During trending days, silver and gold posted the highest percentage of consecutive positive returns, 55% and 53%, respectively, while natural gas posted the highest percentage of consecutive negative returns, spending 54% of its trending time with consecutive losses.

Most of the commodities had larger positive returns than negative returns on opposite consecutive days, with gold and soybeans each recording 54% of consecutive opposite direction days with a larger gain than loss. Corn, the most-trending commodity, showed 52% of its non-trending days with a bigger gain than loss. Copper, one of the least-trending commodities, had 51% of non-trending consecutive days with bigger losses than gains, as did natural gas.

Given that corn trended the most and had relatively large gains to losses on opposite days during the period studied, it may be the best overall commodity choice for 2x leveraged and inverse indices. Natural gas may be a strong choice for an inverse index, based on its high consecutive negative returns and high losses in opposite consecutive daily returns. Copper also had more losses on opposite days, which may be beneficial in its inverse version. Lastly, gold and silver may be good choices for the 2x leveraged indices, based on their high positive consecutive return rates, even though silver was more choppy than trending.

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

The Little Cousin to TIPS

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Peter Tsui

Director, Global Research & Design

S&P Dow Jones Indices

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We explored the topic of building a 30-year TIPS portfolio in a previous blog.  If the numbers we threw around seemed too big (USD 5,000 or USD 10,000 per year over a long period of time) for a Millennial, don’t lose heart.  The U.S. Series I Savings Bonds (or I Bonds) provide an easy way to save for beginners.  Currently, any investor with a social security number can buy up to USD 10,000 per year in I Bonds, with minimum purchase of USD 25 per transaction.  This makes it much easier for a Millennial to put aside, say, USD 31.33 if he wants to save only that much.  Yes, you read that right, you can buy an I Bond to the penny, as long as it is over USD 25.00.

There are some basic differences between TIPS and I Bonds, but essentially both are financial instruments that allow one to hedge against inflation over time.  For a good illustration, please visit the TreasuryDirect website, https://www.treasurydirect.gov/.

Why bother with putting away such a small amount (in this example, USD 31.33)?  This gets at the heart of retirement readiness.  To be retirement ready, one needs to pay attention to three drivers: (1) contribution, (2) investment strategy, and (3) spending goals.  Savings are directly related to the first driver—contribution.  Whether or not retirement has been funded adequately, funding has to begin somewhere.  A thousand-mile journey begins with the first step, as does the wealth accumulation for one’s retirement income, by modest savings.  Once the amount saved has reached some critical mass, more finely calibrated investment strategy can be adopted to further grow the investment assets.  We will leave the last driver—spending goals—alone, for the time being.

I Bonds can be useful in this undertaking of funding for one’s eventual retirement many years down the road as a supplement other funding schemes.  They are meant to be long-term investments, and they continue to earn interest for up to 30 years.  Interest on an I Bond is a combination of two rates: (a) a fixed rate of return, which remains the same throughout the life of the I Bond, and (b) a variable inflation rate, which is calculated twice a year, based on changes in the nonseasonally adjusted Consumer Price Index for all Urban Consumers (CPI-U) for all items, including food and energy (CPI-U for March compared with the CPI-U for September of the same year, and then CPI-U for September compared with the CPI-U for March of the following year).

Currently, the fixed rate of return is close to zero, due to the historically low level of interest rates.  If you were to buy an I Bond now, in the month of April, the April 2017 I Bond issue would have a fixed rate of zero and a semiannual inflation rate of 1.38%, providing an annual composite rate of 2.76%, good for the six months from April to September.  For the six months between October 2017 and March 2018, the semiannual inflation rate would be based on the CPI-U for September 2016 compared with the CPI-U for March of 2017 (which was announced on April 14, 2017 to be 0.98%).  Thus the composite rate for the six months from October 2017 to March 2018 would be 1.96% [=0.0000 + (2 X 0.0098) + (0.0000 X 0.0098) = 0.0196].  So, here is the final tally: an investor who buys the USD 10,000 yearly limit in April 2017 would get a fixed rate of 0.0% and earn USD 138 in the first six months and then a bit more than USD 98 the next six months (due to compounding on the interest accrued), for a total of slightly more than USD 136.

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