Investment Themes

Sign up to receive Indexology® Blog email updates

In This List

Knowing Your Geographic Revenue Exposure: Lessons From Brexit

Asian Fixed Income: Two Growth Segments in China’s Bond Market

Don’t Confuse Income With Yield

Potential Risks When Constructing a Sustainable Lifetime Income

India Passive Story – The Government Catalyst

Knowing Your Geographic Revenue Exposure: Lessons From Brexit

Contributor Image
Phillip Brzenk

Senior Director, Strategy Indices

S&P Dow Jones Indices

two

The so-called “Brexit” referendum result in the UK on June 23, 2016, came as a shock to financial markets, with the S&P United Kingdom LargeMidCap (GBP) falling by over 3% the following day.  As the political and economic outlook became uncertain, the British pound sterling had steep declines against other major currencies including the U.S. dollar (-8%), the euro (-6%), and the yen (-11%).[1]  Not surprisingly, many companies in the index fell in price, as nearly 30% of constituents declined by 10% or more.  However, it was interesting to note that despite the overall market declining, some constituents actually rose, including 8 of the top 10 companies in terms of market capitalization.

Was there an underlying theme as to why certain companies did well when the overall market precipitously declined?  To investigate this, we first look at the average stock return on June 24, 2016, within each sector for any potential insight (see Exhibit 1).  With a general understanding of the commercial characteristics of each sector, it becomes quite clear—sectors that had significant revenue outside of the UK performed relatively better than sectors with substantial domestic revenue.

Several underlying reasons could have a played role in the high dispersion of returns.  First, the higher uncertainty of the future outlook of the UK economy could understandably affect companies with high domestic revenues compared to companies with more diversified and/or foreign sources of revenue by geographic region.  Secondly, the drop in the British pound sterling relative to other global currencies could benefit companies with high foreign revenues, as sales in foreign markets are typically completed in foreign currency.  As companies translate foreign revenues back into a domestically weaker currency, these revenues would be worth more in local currency terms than originally expected (note: this is with an assumption that the company did not employ currency hedging practices).

To investigate the hypothesis further, we formed two hypothetical portfolios, grouped based on the percentage of revenue coming from domestic versus foreign sources, using the S&P United Kingdom LargeMidCap as the underlying universe.  Available geographic revenue data was aggregated for all constituents in the index, and then the universe was separated into quartiles based on each company’s percentage of sales coming from the UK.  The top quartile, which comprised the companies with highest domestic revenues, were compiled into a “domestic revenue” portfolio and the bottom quartile compiled into a “foreign revenue” portfolio.  The portfolios were weighted by each company’s percent of revenue to the targeted geographic area; for the domestic revenue portfolio, companies with the highest revenue exposure to the UK had the highest weights, and for the foreign revenue portfolio, companies with the highest foreign revenue exposure had the highest weights.

To understand how the resulting geographic revenue distribution differed among both portfolios and the benchmark, Exhibit 2 breaks down the weighted average sales percentages in several categories.

The benchmark, composed of only UK-domiciled companies, had total revenues from the UK of just 18%.  The hypothetical portfolios showed a stark contrast in the resulting revenue sources, with the domestic portfolio having 98% exposure to the UK and the foreign portfolio with just 4% of revenue coming from the UK.

We tested to see how the three portfolios have performed since the Brexit vote (see Exhibit 3).

We can see that there has been a significant difference in performance between the domestic and foreign revenue portfolios since Brexit, with the former outperforming the latter by 38%.  Furthermore, the foreign revenue portfolio also outperformed the broad-based UK market during the same period.  The findings highlight the importance of incorporating geographic revenue information into a strategy, in particular if market participants wish to express their views on geographically driven thematic events.

[1] Source: FactSet.  Rounded percentage change of mid-quote for each currency pair on June 24, 2016.

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

Asian Fixed Income: Two Growth Segments in China’s Bond Market

Contributor Image
Michele Leung

Director, Fixed Income Indices

S&P Dow Jones Indices

two

China’s bond market continued to expand in 2017.  The local currency bond market, as tracked by the S&P China Bond Index, grew over 19% in the past year.  As of June 30, 2017, the S&P China Bond Index tracked 9,342 bonds with a market value of CNY 51 billion.  Two segments that recorded robust growth were the provincial and corporate bonds.

The S&P China Provincial Bond Index seeks to measure the performance of local government bonds, which have experienced significant growth since the municipal replacement program in 2015 (see previous blog on this subject).  The index market value increased from less than CNY 1 trillion in 2015 to its current value of CNY 10 trillion.  The infrastructure investment is the main driver of the funding demand.  Yet, the strong issuance also underscored the heightening risk, as the indebtedness of the local government surged.  According to the index, the most indebted provinces are Jiangsu, Zhejiang, and Shandong.

The market value of the S&P China Corporate Bond Index also gained 15% in the past year. On the back of the deleveraging campaign and rising default risks, market participants tend to seek high quality bonds.  The S&P China High Quality Corporate Bond 3-7 Year Index is designed to measure high-quality corporate bonds, according to our two-tier screening approach.  First, issuers must be rated investment grade by at least one of the international rating agencies; and second, securities must be rated ‘AAA’ by at least one of the local Chinese rating agencies.  The index proved its resilience in a recent sell-off versus its parent index.

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

Don’t Confuse Income With Yield

Contributor Image
Philip Murphy

Managing Director, Global Head of Index Governance

S&P Dow Jones Indices

two

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

Contributor Image
Peter Tsui

Director, Global Research & Design

S&P Dow Jones Indices

two

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

Contributor Image
Koel Ghosh

Head of South Asia

S&P Dow Jones Indices

two

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.