Investment Themes

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In This List

Don’t Confuse Income With Yield

Potential Risks When Constructing a Sustainable Lifetime Income

India Passive Story – The Government Catalyst

Retail Fee Premium and its Impact on Fund’s Performance: Observations From SPIVA® Institutional Year-End 2016 Scorecard

Chinese Demand Growth Lifts Every Commodity

Don’t Confuse Income With Yield

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Philip Murphy

Managing Director, Global Head of Index Governance

S&P Dow Jones Indices

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Yield conventions differ for stocks and bonds, but the various calculation methods for both asset classes have an important characteristic in common—they are alternative expressions of price.  Measures of yield specifically relate current price to how much dividend or interest income holders of a particular security are likely to get.  Thinking of yield as income itself is like thinking of a stock’s PE as its earnings.  The latter is what you have an economic claim on as a shareholder and the former is an expression of how much you would currently pay to get it.  So, if yield is the price of income, what do low yields tell us?  Just as a high PE (low earnings yield) indicates that buying an earnings stream is relatively expensive, a low dividend yield (high price to dividend ratio) or yield to maturity tells us that buying income is relatively expensive.

Whatever its current price, income is what we live on in retirement, not yield.  Chasing yield may stem from the old-school approach of living off bond coupons without invading principal.  During higher interest rate regimes of past years, this approach seemed reasonable and may have worked for many.  In 1980, 10-year Treasury rates exceeded 10% and were on their way to peaking over 15% in 1981.  However, for several well-documented reasons, this strategy is generally less realistic today.  First of all, the income “gap” that many people needed to fund with personal savings was, on average, probably lower then because income from guaranteed sources was generally higher.  Not everyone had guaranteed pensions but many more did than today, and the Social Security retirement program was not jeopardized as it may (partially) be for future beneficiaries.  Secondly, in the early 1980s, life expectancy of all 65-year-olds was about 16½ years.  As of 2010, it was over 19 years.  Many of today’s workers will need to fund longer retirements, of uncertain duration, with less guaranteed lifetime income.  Longer lives shine light on another disadvantage of the coupon clipping strategy; it relies at least partially upon money illusion.  Higher rates generally imply higher inflation expectations.  Over shorter time periods, the compounding effect of inflation may be moderate, but with ever-longer funding horizons even modest inflation can significantly erode purchasing power.

Finally, as market interest rates change, a big disadvantage of chasing yield is that it may result in unintended shifts of underlying risk in order to maintain portfolio yield.  As explained by Charles Schwab Investment Management, and covered in a recent PlanSponsor article,[1] maintaining a given yield level implies adding credit risk when interest rates decline.  Perhaps the worst part about relying on yield to fund retirement income is that one is beholden to market rates.  Retirement income is too important to leave to chance.

Rather than chasing yield, or relying exclusively upon coupon interest and dividend payments for future income, many market participants could better prepare themselves for retirement by developing prudent withdrawal plans funded by accumulated savings.  Withdrawal planning can take sources of guaranteed income into account such as pensions, annuities, bond holdings, and expected Social Security benefits, and it can also allow for maintenance of reasonable allocations to a diversified basket of growth assets.

[1]   http://www.plansponsor.com/uncovering-hidden-risks-in-fixed-income-target-date-fund-allocations/?fullstory=true

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

Potential Risks When Constructing a Sustainable Lifetime Income

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Peter Tsui

Director, Global Research & Design

S&P Dow Jones Indices

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In retirement, financial ruin is taken to mean when one’s savings have been depleted before one passes away.  If one’s savings are invested in a diversified portfolio, financial ruin is taken to mean the combined effects of withdrawals and adverse market conditions that can potentially deplete the portfolio before one’s passing.

Financial ruin to one’s portfolio can stem from three specific drivers:

  1. Longevity: The longer one lives, the greater the burden on the funding portfolio;
  2. Random market conditions: Market returns are not uniformly distributed, and thus some retirees may experience more adverse conditions than others; and
  3. Withdrawals: If the initial distribution from the funding portfolio were excessive, it would accelerate the depletion of the portfolio in the event that the portfolio went through unfavorable market conditions.

To be able to see potential ruin to one’s portfolio over the long-term horizon would bring great insight to one’s financial well-being.  The notion of a coverage ratio, defined as the proportion of available assets to the annual spending gap, can be a handy tool.  The annual spending gap is defined as the spending needs required after taking into account all sources of dependable income, such as social security benefits, pensions, and income and dividends from one’s investments.  Thus, if one’s annual spending gap is USD 40,000 a year, and one’s available assets are USD 1,000,000, then one’s coverage ratio equals 25.

A more sophisticated way of measuring the probability of ruin was presented in a 2004 paper entitled “Ruined Moments in Your Life: How Good are the Approximations?”[1] written by a trio of professors at York University.  They determined that a coverage ratio (or margin of safety) of roughly 30 for a balanced fund would have a 95% chance of success (i.e., sustainable lifetime income).  The flip side of this 95% chance of success is equal to a 5% chance of lifetime ruin probability.

If retirees can maintain their lifetime ruin probability at 5% by making changes to their withdrawal strategy as needed, they should be in good shape for their retirement.

[1]   Huang, H, M.A. Milevsky, and J. Wang (2004), Ruined Moments in Your Life: How Good are the Approximations? Insurance: Mathematics and Economics, Vol. 34, pg. 421-227.

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

India Passive Story – The Government Catalyst

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Koel Ghosh

Head of South Asia

S&P Dow Jones Indices

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Passive investing in India has experienced a remarkable growth story, and the last few years have witnessed an exponential increase in both assets and products in the region.  India is among the leading countries in terms of the rate of growth of the exchange-traded fund (ETF) market, as assets have more than doubled in the past three years.[1]  Currently, with ETF assets of over USD 5 billion and nearly 65 products, the Indian passive space seems to be geared to reach new heights.  The ETF growth that took off with the popularity of gold ETFs spearheaded to a new direction when the Indian Government announced its divestment plan via an ETF in 2013.

In 1991, the government of India made their decision on disinvestment wherein selected public sector undertakings would be chosen to divest the government majority stake.  This was not met with much success initially and to further this initiative, the government announced the ETF route.  This was a landmark decision and the first of its kind.  The first ETF was launched by Goldman Sachs in 2014 and managed to garner nearly INR 3,000 crore in assets.  Earlier this year, further tranches of the ETF were received with much interest by market participants and the ETF market now has assets of INR 5,781 crore, as of July 31, 2017.[2]

Furthermore, the Indian Government promoted the ETF industry when the Ministry of Labour and Employment announced its decision to invest 5% of its incremental flows into the Employees Provident Fund Organization (EPFO) into ETFs.  This was another major boost to the market, as being the largest provident fund in India, this was definitely good news for ETF markets.  In the first year (2015-2016), EPFO invested assets worth INR 6,577 crore, while the figure for 2016-2017 stood at INR 14,982 crore[3] across the S&P BSE SENSEX ETF and the Nifty 50ETF.  The ministry has further catalyzed the market over the years by increasing this allocation from 5% to 15%, thereby aiding the growth of assets in this space.  The change in investment norms has resulted in encouragement for other retirement funds to follow suite and further grow the rising ETF market.

The latest government catalyst has been the announcement of the second disinvestment ETF, which is aimed at contributing to the disinvestment target for the current fiscal year.  The targeted disinvestment for fiscal year 2017-2018 is pegged at INR 72,500 crores of which over INR 8,427.59 crore (as of Aug. 3, 2017)[4] has been raised so far.  The second ETF vehicle is not only aimed at being instrumental to achieving the target but will result in a further impetus to Indian ETF markets.

The announcement on Aug. 4, 2017, by the Finance Minister Mr. Arun Jaitley declared the new ETF as Bharat 22, which is based on the S&P BSE Bharat 22 Index, with Asia Index Private Limited as the index provider and ICICI Prudential AMC as the product issuer.  The S&P BSE Bharat 22 Index is designed to track the performance of select companies divested via the new ETF route by the Department of Investment and Public Asset Management (DIPAM).

As ETFs are effective, transparent, flexible, and cost-efficient investment vehicles, they can provide market participants the benefit of accessing the market via a diverse portfolio at a low cost.  They are transparent, as the underlying stocks are traded real time and their prices are available in the public domain.  ETFs are traded on an exchange similar to stocks so they offer flexibility and liquidity in an investment vehicle.

Thereby, the Indian government is offering the opportunity for market participants to access a diversified basket of select companies and participate in the disinvestment story via this ETF.

[1] Source: ETFGI

[2] Source: Value Research

[3] Source: Economic Times, May 28, 2017

[4] Source: DIPAM

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

Retail Fee Premium and its Impact on Fund’s Performance: Observations From SPIVA® Institutional Year-End 2016 Scorecard

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Ryan Poirier

Senior Analyst, Global Research & Design

S&P Dow Jones Indices

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The impact of fees on managers’ performance continues to make headlines.  With the most recent round of actively managed fee reductions[1] taking place in February 2017, market participants can benefit from lower fees as managers compete for capital.  In the recently issued “SPIVA Institutional Scorecard – How Much Do Fees Affect the Active Versus Passive Debate?” we look at differences in the fee structure between institutional separately managed accounts and retail mutual funds, as well as the impact on managers’ performance.  Based on the data, we can observe that, in general, mutual funds cost more than their institutional counterparts across domestic equity categories (see Exhibit 1).

Exhibit 1 shows the median fees by the type of strategy, ranking from least expensive to most expensive.  The data shows that for both institutional SMAs and retail mutual funds, large-cap and small-cap spaces align in their rankings as the least and most expensive, respectively.  Furthermore, the “retail fee premium” (as measured by the spread between the circles and triangles) that retail market participants are paying is the highest in the mid-cap space.  The spread then narrows for multi-cap funds.

Even the same amount of fees can make a meaningful distinction between a winning and a losing manager depending on the distribution of returns around the index.  For example, if most funds in a particular category have returns that are either +/-5% relative to the benchmark, then a 1% fee will not change the percentage of funds underperforming.  On the contrary, if most funds have relative returns that are from +0% to +0.99%, then the underperforming percentage could be dramatically higher after subtracting the 1% fee.

The fee premium that we noted in Exhibit 1 results in a lower percentage of retail mutual funds outperforming the benchmarks, compared to institutional funds.  The average and median fee premium across all categories is equivalent to 0.32%.  On average, across all segments of the U.S. equity market, the additional expense paid by retail market participants leads to approximately 3.05% more funds underperforming their respective benchmark.  This figure is derived by subtracting the average of the blue bars in Exhibit 3 (13.61%) from the average of the blue bars in Exhibit 2 (10.56%).

The full breakdown of both institutional funds and retail funds can be seen below.

In fixed income markets, municipal debt is one area where the greatest performance differential between retail and institutional funds occurs.  We find that the average fee for an institutional municipal strategy is 0.35%, whereas that of a retail municipal fund is 0.75%.  While the fee premium is on par with that of equities, the gap in municipals has led to a large difference in the amount of funds that have outperformed (see Exhibit 4).

Within the municipal market, retail market participants fared better than institutional ones when measured on a net-of-fees basis (27% retail funds versus 22% institutional funds outperforming).  However, when gross-of-fees returns are used, in order to measure the impact of fees (i.e., the length of the blue bar in Exhibit 4), retail market participants lose much more.  In other words, the fees for retail mutual funds weaken about 50% of the gross-of-fees outperformance whereas only about one-third is lost in the institutional space.

As the active versus passive landscape evolves and actively managed strategies increasingly compete with passive funds for capital, it is inevitable that fees will continue to be in the headlines.  With the publication of the SPIVA Institutional Scorecard, market participants now have a tool at their disposal to examine the impact that fees make on the chance to outperform in various asset classes.

[1]   https://www.bloomberg.com/news/articles/2017-02-24/vanguard-cuts-etf-fees-as-race-to-zero-with-blackrock-heats-up

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

Chinese Demand Growth Lifts Every Commodity

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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Many news headlines point to rising or falling Chinese demand growth as a main influence of commodity performance.  However, there are many other fundamentals like the U.S. dollar and interest rates that drive commodities.  Even in the Chinese market, there are forces besides demand growth like demand for storage and demand for metals to be used as financial collateral.  So, in this analysis, the impact of Chinese demand growth changes on overall commodities, sectors and individual commodities is examined, using year-over-year data from 1970.

Overall the S&P GSCI only moves in the same direction as Chinese GDP growth changes in about 57% or 26 of 46 years. However, when the Chinese GDP growth is split into rising and falling periods, commodity returns seem to be more influenced by rising growth than slowing growth.  Of the 46 years, growth rose 19 times with 15 or 79% positive annual commodity returns.  The slowing growth years were much less influential, driving down commodity performance in only 11 of 27 years, or in 41% of time.  Though, big negative years like in 1976, 1981, 1986, 2008, and times with consecutive years of falling growth like in 1997-98, 2013-15 seemed to bring commodities down.

Source: S&P Dow Jones Indices.  Bloomberg Chinese GDP growth data. Green bars show simultaneous positive Chinese GDP growth changes and positive commodity returns. Pink bars show simultaneous negative Chinese GDP growth changes and negative commodity returns.

Additionally, it is infrequent to see all five sectors move together in the same direction with Chinese GDP growth changes, but again they are more influenced by rising growth.  All sectors moved with demand growth in 21.7%, or in 10 of 46 years.  However, all sectors gained in 26.3%, or in 5 of 19 rising demand growth years, while all sectors lost in just 18.5%, or in 5 of 26 slowing demand growth years.

Source: Bloomberg and S&P Dow Jones Indices.

The evidence shows diversification protects the S&P GSCI from slowing Chinese demand growth and helps with rising growth.  The composite index loses in just 40.7% of falling growth periods, which is less frequently than any single sector loses with falling growth.  It is interesting that industrial metals, which is comprised largely (over 40%) of copper, is the least sensitive sector to rising Chinese GDP growth, rising in just 53% of years together.  It is also interesting that energy is the least sensitive to falling growth, dropping together in just 43% of years.  The least generally sensitive sectors to macro factors, agriculture and livestock, have historically been most influenced by moves in Chinese GDP growth.

Source: S&P Dow Jones Indices

Agriculture and livestock are also the only sectors that lose on average for every 1% drop in Chinese GDP growth.  While a 1% rise in Chinese GDP growth helps every sector, a 1% drop in Chinese GDP growth only reduces positive returns overall and for metals and energy.  For precious metals, although the direction of returns and Chinese GDP growth changes moves together more frequently up than down, the average returns for a 1% Chinese GDP growth move in either direction is about the same.

Source: S&P Dow Jones Indices

Lastly, every single commodity in the S&P GSCI rises with rising Chinese GDP growth, while only wheat, cotton, gasoil, Brent crude and natural gas seem to fall on average with a 1% drop in Chinese GDP growth.

Source: S&P Dow Jones Indices

The rise in natural gas may be more coincidental since U.S. supplies accounted for 7% of China’s LNG imports (in March 2017.)  Additionally, the World Economic Outlook in October 2015 stated, “Notwithstanding the dramatic increase in Chinese imports of metals, these represent less than 2 percent of China’s GDP.”  These regional and commodity specific factors are important to note when realizing potential differences in commodity performance from Chinese GDP growth changes.

 

 

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