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Don't Shoot the Messenger

Why Did the Majority of A-REIT Funds Outperform in the Past 12 Months?

Impact of Term Structure on VIX® Futures Correlation with Bond Sectors

SPIVA Europe Mid-Year 2017 Scorecard: Active Versus Passive – Consistency Is Key

Market Agnosticism

Don't Shoot the Messenger

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Anu Ganti

Senior Director, Index Investment Strategy

S&P Dow Jones Indices

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Here are some recent headlines about the consequences of passive investing:

Japan Central Bank’s ETF Shopping Spree Is Becoming a Worry

Passive Market Share to Overtake Active in the US No Later than 2024

Passive investing boom is creating a ‘frightening’ risk for markets

ETFs are taking over the world, and there’s nothing anyone can do to stop them

Let’s Prevent ETFs from Eating the Economy

What all these headlines have in common is that they are inherently misleading.  For instance, the first statement reflects a common misconception that the Bank of Japan (BoJ) owns more than two-thirds of the Japanese stock market.  In fact, the BoJ owns 70% of listed ETFs, and only 2.5% of the capitalization of the market—not exactly an eye-catching headline.  Understanding the importance of passive investing requires us to get both the numerator (passive AUM) and denominator (total market capitalization) correct, and much press commentary is mistaken about one or both.

Calculated properly, how large is passive investing?  S&P DJI’s annual asset survey shows that 15% of the S&P 500®’s capitalization is held in S&P 500 index-based funds.  Expanding these numbers to cover mid- and small-caps as well as other index providers, we estimate that 20% of total U.S. market capitalization is held by passive trackers.  This estimate excludes the factor indices that underlie “smart beta” ETFs.  Factor strategies are not price takers—they trade on fundamental metrics like value or momentum, in much the same way (although at different frequencies) as active managers.

So what does 20% passive market share imply for market efficiency?  Not much.  It is trading, not asset ownership per se, that sets prices, and passive funds’ share of trading is much less than their share of AUM.  Under reasonable assumptions, if index funds’ share of AUM is 20%, their share of total trading would be approximately 5%.  Even if index assets rose to 50% of AUM, which is a commonly expressed fear from the active side, the passive share of trading would still be less than 20%.  Passive price takers are a long way from controlling the market and causing inefficiencies.

Fifty years ago, 100% of market capitalization was actively managed; the shift to 20% passive, with more possibly to come, surely is one of the most important developments in modern financial history.  But it’s important not to confuse means and ends.  The shift to passive management has been, and continues to be, driven by the persistent underperformance of active managersPassive growth is the consequence, not the cause, of active underperformance.  To argue otherwise is to misunderstand the most important thing about it.

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

Why Did the Majority of A-REIT Funds Outperform in the Past 12 Months?

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Priscilla Luk

Managing Director, Global Research & Design, APAC

S&P Dow Jones Indices

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In the mid-year 2017 SPIVA® Australia Scorecard, the majority of Australian funds underperformed their respective benchmarks across most categories, similar to previous scorecards.  More than 80% of Australian Mid- and Small-Cap funds underperformed the S&P/ASX Mid-Small over the past 12 months.  In contrast, A-REIT funds stood out as the best-performing category versus their benchmark, the S&P/ASX 200 A-REIT, with 87.5% of funds outperforming over the past 12 months (see Exhibit 1).

With falling bond prices and rising bond yields, the S&P/ASX 200 A-REIT declined 11.1% from July 2016 to June 2017, while A-REIT funds suffered less, with losses of 8.6% and 8.3% on an equal- and asset-weighted basis, respectively.  Historically, the most significant benchmark-relative outperformance of A-REIT funds was seen during the global financial crisis in 2008 (see Exhibit 2).

Evidently, the vast majority of A-REIT funds tended to be more defensive than their benchmark over the past five years, as most of them recorded less volatile returns over the one-, three-, and five-year periods.  This characteristic seems to be unique to funds in the A-REIT category and has not been observed in other Australian fund categories (see Exhibit 3).

As Australian A-REIT funds have experienced an extended bull market after the global financial crisis, the majority of the defensive A-REIT funds delivered less pronounced returns than the S&P/ASX 200 A-REIT for most of the time during this period, until the A-REIT sector began to decline in late 2016.  Due to the significant difference in return volatility of A-REIT funds versus their benchmark, measuring A-REIT funds’ performance on a risk-adjusted basis (amount of return divided by amount of risk over the same period) compared with the benchmark is important supplementary information, in particular to A-REIT investors.

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

Impact of Term Structure on VIX® Futures Correlation with Bond Sectors

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Berlinda Liu

Director, Global Research & Design

S&P Dow Jones Indices

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Recently my colleague wrote about the correlation between VIX (spot and futures) and two credit sectors (high-yield and emerging market bonds).  The blog shows that VIX futures exhibit stronger negative correlation than VIX spot and that this stronger negative correlation of bonds to VIX futures than to VIX spot comes mostly from down markets.  In this blog, we further explore the asymmetric correlation between VIX futures and those two credit sectors.

Not limited to VIX, futures markets in general do not tend to move with the spot in the same magnitude.  On rare occasions, the two may even move in opposite directions.  When trading futures, market participants need to take into account an additional cost, the so-called “cost of carry,” of maintaining or holding a position in the market.  The cost of carry can appear in different ways, including interest on bonds, storage cost of commodities, and, in the VIX futures market, roll cost of futures contracts.

The stronger negative correlation of credit bonds to VIX futures than to VIX spot could be explained largely by the change in the futures curve when VIX spikes.  In other words, when the high-yield and emerging bond market is in distress, VIX goes up and the VIX futures curve flips from contango to backwardation, which causes VIX futures to move even further in the opposite direction of the high-yield and emerging market bonds.

To verify this conjecture, we calculated the monthly average roll cost of the S&P 500® VIX Short-Term Futures Index as the monthly average slope between the first-month futures and the second-month futures.  A positive roll cost indicates cost while a negative roll cost indicates yield.

Exhibits 1a and 1b show the monthly roll cost of the S&P 500 VIX Short-Term Futures Index in the months when high-yield and emerging market bonds posted losses between February 2006 and April 2007.  When high-yield bonds were down, the correlation between their monthly return and the monthly roll cost of VIX futures was 75%, indicating that the VIX futures curve was more likely to be in backwardation.  When emerging market bonds were down, the correlation between their monthly return and the monthly roll cost of VIX futures was 56%, also an indicator of backwardation in the VIX futures curve.

Exhibits 1a and 1b also show that larger loss in high-yield and emerging market bonds was usually associated with higher roll yield from VIX futures backwardation.  This is further illustrated in Exhibits 2a and 2b; in the months that high-yield and emerging market bonds posted a loss of more than 3%, VIX futures ten   ded to rise, sometimes even more than the VIX spot, due to the backwardation in the VIX futures curve (or, in other worlds, the yield from the roll of a long VIX futures position).

From the above observation, we conclude that backwardation in the futures term structure explains the stronger correlation between VIX futures and these two bond sectors in down markets.

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

SPIVA Europe Mid-Year 2017 Scorecard: Active Versus Passive – Consistency Is Key

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Andrew Innes

Head of EMEA, Global Research & Design

S&P Dow Jones Indices

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It’s that time of the year and the highly anticipated SPIVA Europe Mid-Year 2017 Scorecard is out.  European active fund managers are no doubt apprehensively looking to see how their industry is competing with the performance of their respective S&P DJI benchmark indices.

At first glance, active proponents may breathe a sigh of relief for doing better than usual over the past year.  After all, when comparing the 50.9% of actively managed European equity funds that underperformed their passive benchmark from mid-2016 to mid-2017, they may argue it is considerably better than the equivalent figure of 80.4% reported in the SPIVA Europe Year-End 2016 Scorecard.  Active managers in several countries, most notably the UK, France, Denmark, and Switzerland, may go as far as celebrating that more than half of funds investing in equities in the region outperformed over the past year.

The reality is that active funds investing in pan-European equities collectively failed to beat the benchmark over the past year.  The S&P Europe 350 showed an impressive one-year return of 18.6%, while euro-denominated active funds investing in pan-European equities underperformed, with an average asset-weighted performance of 17.6%.  Even more interesting is that the annual return of the average stock within the benchmark was 23.3%, represented by the S&P Europe 350 Equal Weight Index.  This means that the mean return of a large group of randomly weighted portfolios would have likely outperformed the S&P Europe 350 by a significant margin.

But to avoid any shortsightedness in the analysis of the latest SPIVA Europe Scorecard, let’s step back to observe the consistency in the results from active equity fund managers.  So instead of just looking at the number of funds in Europe that underperformed over the past year, we took a look over a longer time frame.  In doing so, looking over the past 10 years, we found the percentage of actively managed funds across each category in the SPIVA Europe Scorecard that underperformed the benchmark ranged from 72-98%.  Therefore, finding funds that will outperform their benchmarks over the long-term appears to be the real skill.

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

Market Agnosticism

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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 weekend’s Financial Times brought John Authers’ provocative article on the frequency of financial crises.  Along the way, John gives us some excellent advice: “We should all work on the assumption that we do not know what will happen next.”

John’s view of crisis prediction applies equally to the quotidian work of investment management.  Since we don’t know which styles or managers will be in favor next quarter or next year, how should investors manage their agnosticism?  If we can’t know the future, we can at least rely on historical patterns of behavior.  One such pattern, with a pedigree of more than eight decades, is the observation that most active managers underperform passive benchmarks.  There are good theoretical reasons why this should be true, stemming most convincingly from the zero-sum nature of professional investment management.  If I’m to be above average, someone else has to be below average, and the weighted sum of the winners’ outperformance is exactly equal to the weighted sum of the losers’ underperformance — before costs.  The incremental costs of active management place active investors, as a group, at a permanent disadvantage relative to their passive competitors.

The theoretical argument is borne out by a virtual catalog of empirical data, most recently including our mid-year SPIVA report for the U.S. market.  For the 12 months ended June 30, 2017, 57% of large-cap U.S. equity fund managers underperformed the S&P 500.  Current results are somewhat worse for mid- and small-cap managers, and significantly worse across all cap ranges when the time horizon extends to three or five years.

We don’t know what will happen next year; we don’t know which active managers will outperform and which will fail.  What we do know is that investors who put index funds at the core of their portfolios have outperformed most active managers most of the time.  Investors who act accordingly have the odds on their side.

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