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A Study of the Classics – Part 1

Does Factor Investing Deserve More Attention in Hong Kong?

Green Bond Market: October 2017

Are Quality Stocks Expensive in China?

Income Is Expensive but Don’t Wait for a Free Lunch

A Study of the Classics – Part 1

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Jamie Farmer

Chief Commercial Officer

S&P Dow Jones Indices

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During a recent retreat to the Blue Ridge Mountains, I picked up a copy of Outside Magazine’s 40th Anniversary issue.  Nursing two fingers of bourbon, I paged through their feature on the seven most classic pieces of adventure gear.  Generally, it’s a great list.  Number 4, Ray-Ban Aviators?  Absolutely.  Number 7, Birkenstock sandals?  Yeah…no.  But then, I never was much of a fan of The Grateful Dead.

Being an index geek, I found myself ruminating on the classics of indexing (yes, I’ll concede that’s a little sad).  What, I pondered, were the seminal pieces of benchmark design, those major milestones in the evolution of the passive discipline?  I suspect more learned (and less rushed) experts would: a) find more than seven selections and b) most likely argue with my choices and omissions.  But this is my blog post, so…

Dow Jones Railroad Average (1884): Many often mistakenly credit the Dow Jones Industrial Average® as the first mainstream stock market index.  In fact, that honor falls to Charles Dow’s Railroad Average, created 12 years prior to the DJIA.   At the time, railroads dominated the corporate ranks and represented the natural subject for Dow’s first index of share price performance (though, in fact, 2 of the original 11 companies—Western Union and the Pacific Mail Steamship Company—were not railroads at all).  Price-weighted,—the only methodology realistically available to Mr. Dow at genesis—the Dow Jones Railroad Average was renamed the Dow Jones Transportation Average in 1970 to reflect the increasing diversity of its composition (airlines, marine, delivery services, etc.).

S&P 500® (1957): Originally launched in 1923 as the “Standard Composite Stock Price Index”—and tracking only 223 companies at inception—the S&P 500 reached its namesake component count in 1957, an advancement made possible by the application of computing power to the daily calculation.  The S&P 500 and its predecessors were capitalization-weighted (unlike the Dow Averages), so a company’s weight in the index is proportionate to its total value, not just to its stock price.  Until April 1988, the index held fixed sector allocations of 400 industrials, 20 transports, 40 utilities, and 40 financials.  Those counts were abandoned as, again, the landscape of listed U.S. companies evolved; today, the S&P 500 includes representation from all 11 GICS® sectors.  Most knowledgeable observers know that the S&P 500 comprises 500 large U.S. companies, not the 500 largest U.S. companies.  Maintained by the S&P Dow Jones Index Committee, the S&P 500 is the definitive benchmark for the large cap stock market and the standard against which market participants are most commonly measured.  As our SPIVA research repeatedly bears out, it’s a standard that most professional money managers fail to beat.

S&P GSCI (1991): While not the world’s first commodity index, the S&P GSCI was the first readily tradable commodity index and thus offered much greater utility.  Prior attempts at the indexation of price movements within the commodities market included less liquid futures contracts and spot commodity prices, which are generally inaccessible by the investing public.  Originally developed by Goldman Sachs (hence the “GS”), the S&P GSCI only includes the most liquid commodity futures and is weighted according to the global production of constituent commodities to ensure that influence aligns with economic significance.  In the nearly three decades since its launch, the flagship index—and its many sector, strategy, and enhanced progeny—has been the leading market barometer as market participants have increasingly accepted the diversification benefits of commodities.

To be continued…

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

Does Factor Investing Deserve More Attention in Hong Kong?

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Priscilla Luk

Managing Director, Global Research & Design, APAC

S&P Dow Jones Indices

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Factor investing, which is also broadly referred to as smart beta, has gained popularity in the global asset management industry, especially in the exchange-traded funds segment.  Factor-based index-linked products are used as cost-effective tools to enhance return or reduce risk by increasing number of market participants in the U.S., with 20.9% of U.S. ETP assets represented by factor-based products as of June 2017.  In the Asia Pacific region, factor-based ETPs only accounted for 4.3% of regional ETP assets.  The adoption of factor-based products by market participants in the Hong Kong market has been far behind other Asian markets such as Australia and Japan.

Since the launch of the Hong Kong-Mainland Stock Connect programs, there has been a growing market demand for factor-based index-linked products for Hong Kong equities.  Due to the tight control on the Qualified Domestic Institutional Investor (QDII) quota, stock connect programs have become favorable channels for mainland Chinese asset managers to gain offshore diversification.  Exploiting the benefit of factor-based investing may help them to deliver better returns in their offshore portfolios.

The Hong Kong equity market reflects the local economy as well as mainland China’s economy, while Hong Kong’s exchange rate is pegged to the U.S. dollar and Hong Kong interest rates primarily follow the U.S. interest rate cycles.  This poses challenges to portfolio management for Hong Kong equities, especially when the Chinese and U.S. economic growth and inflation diverge.  It is doubtful whether the factor-based strategies, which are commonly used by market participants in foreign markets to enhance portfolio performance, behaved in similar ways as seen in other markets.

In our recently published research “How Smart Beta Strategies Work in the Hong Kong Market”, we examined the effectiveness of six well-known risk factors— size, value, low volatility, momentum, quality, and dividend— in the Hong Kong equity market and we observed, apart from small caps, that all of these factors delivered return alpha over the long term on an absolute and risk-adjusted basis, historically.[1]  The hypothetical portfolios for value and dividend delivered the highest excess returns, while those for low volatility and quality showed reduced volatility compared to the underlying benchmark.  The historical risk/return profile of the factor portfolios in Hong Kong broadly aligned with those in the U.S., apart from the small-cap factor.

Our macro regime analysis on the Hong Kong equity factor portfolios suggested that these portfolios are sensitive to the local equity market cycles and investor sentiment regimes.  The low volatility and quality portfolios tended to be most defensive in response to the market cycles and their performances were the least vulnerable to bearish investor sentiment.  In contrast, small-cap and momentum stocks were most cyclical across market cycles and they were most rewarded when investor sentiment was bullish on the equity market (see Exhibit 3). Because of the distinct cyclicality in factor performance, factor portfolios could also be potential tools for market participants to implement their active views on the Hong Kong equity market.

[1]   Based on the 50-stock hypothetical factor portfolios selected from the S&P Access Hong Kong Index universe, please see full report for details.  The S&P Access Hong Kong Index is designed to reflect the universe of Hong Kong-listed stocks available to Chinese mainland market participants through the Southbound Trading Segments of the Shanghai-Hong Kong Stock Connect and Shenzhen-Hong Kong Stock Connect Programs.

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

Green Bond Market: October 2017

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Dennis Badlyans

Associate Director, Global Research & Design

S&P Dow Jones Indices

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In October 2017, nearly USD 10 billion of green bonds were issued, bringing the total to USD 94 billion YTD (see Exhibit 1).  The pace was slower than the record USD 15 billion of issuance seen in September 2017; however, if history repeats itself, November 2017 may give us another record month.  Germany led the pack in October, accounting for 32% (USD 3 billion) of the issuance, followed by China with 22.5% (USD 2.1 billion).

Issuance of green bonds in China has primarily come from commercial banks amid the government’s increased focus on and prioritization of the environmental concerns.  Despite being a latecomer to the green bond market, China is the third-largest issuer, following supranational entities and U.S.-domiciled entities.  After the debut issuance by the Agricultural Bank of China in October of 2015, the country accounts for 14.1% of the green bond market.  After the drastic measures recently taken by the government in shuttering factories, project-based issuance may become a vital lifeline to many companies in affected regions.

The majority of the new issuance in October qualified for the S&P Green Bond Index, which is designed to track the global green market.  Of those bonds, 70% qualified for the S&P Green Bond Select Index, which further limits exposure subject to stringent financial and extra-financial eligibility criteria (see Exhibit 3).  As of Nov. 1, 2017, the global green market had USD 242.4 billion of outstanding debt, USD 220.0 billion of which is included in the S&P Green Bond Index, with USD 172.0 billion in the S&P Green Bond Select Index.

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

Are Quality Stocks Expensive in China?

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Liyu Zeng

Director, Global Research & Design

S&P Dow Jones Indices

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Quality investing has been one of the most widely accepted investment philosophies.  The attractiveness of quality stocks stems from their defensive nature under distressed market conditions.  In China’s A-Share market, quality stocks have gained renewed attraction in 2017.  In the first nine months of 2017, the quality portfolio outperformed the other factor portfolios in absolute terms (see Exhibit 1).

The S&P Access China A-Share Dividend Opportunities was launched on Sept. 11, 2008.[1]  All other portfolios are hypothetical portfolios based on the same starting universe.[2]  The top 100 stocks with the highest factor scores in the eligible universe are selected, subject to a 20% rebalance buffer by number of stocks, following the corresponding standard S&P DJI methodologies.[3]
Source: S&P Dow Jones Indices LLC.  Data from Dec. 31, 2016, to Sept. 29, 2017.  Index performance based on total return in RMB.  Past performance is no guarantee of future results.  Chart is provided for illustrative purposes and reflects hypothetical historical performance.

As the prices of quality stocks rise, the risk of paying too much for good quality stocks may become a concern for market participants.  As of Sept. 29, 2017, compared to the respective eligible universe, the S&P China A-Share Quality Portfolio exhibited strong tilts toward quality features (high profit margin, low financial leverage, and low accrual ratio) and defensive features (low beta and low volatility) as expected.  However, it also exhibited unintended tilts toward more expensive valuations (higher price-to-book and high price-to-sales ratios).

The S&P China A-Share Quality Portfolio is a hypothetical portfolio.
Source: S&P Dow Jones Indices LLC and Factset.  Data as of Sept. 29, 2017.  Chart is provided for illustrative purposes and reflects hypothetical historical performance.  Characteristic tilts are calculated as the weighted Welch’s T-test relative to the eligible universe disclosed in footnote 3.  Positive/negative tilt to a certain parameter denotes that the S&P China A-Share Quality Portfolio had higher/lower value in that parameter than of the eligible universe.[4]

Exhibit 3 further extended the analysis on the historical valuation of the S&P China A-Share Quality Portfolio.  As we can see, quality stocks have been relatively expensive not just recently, but consistently in the history.  From June 2006 to September 2017, the S&P China A-Share Quality Portfolio tended to have relatively higher price-to-fundamental ratios, especially price-to-book, price-to-sales, and price-to-cash flow ratios, than its corresponding eligible universe.

To avoid buying into overvalued high-quality stocks, a natural approach would be to apply a secondary value screen on the quality portfolio to exclude relatively expensive quality stocks.

Based on what we have observed in other markets,[5] value portfolios and quality portfolios tend to have low correlation in performance and tend to exhibit distinct cyclicality.  We found that in China’s A-share market, that the rolling 250-day correlation between the excess returns of the quality portfolio and value portfolio over the 10-year period were fairly low, most of the time in negative domain, which suggests the potential diversification benefits for combining these two factors in portfolio construction (see Exhibit 4).

The S&P China A-Share Quality Portfolio is a hypothetical portfolio.
Source: S&P Dow Jones Indices LLC and Factset.  Data as of the end of June and December each year from 2006 and 2017, as well as Sept. 29, 2017.  Charts are provided for illustrative purposes and reflects hypothetical historical performance.

S&P China A-Share Quality Portfolio and S&P China A-Share Enhanced Value Portfolio are hypothetical portfolios.
Source: S&P Dow Jones Indices LLC.  Correlation was calculated based on the daily excess returns in RMB relative to the S&P China A BMI from June 30, 2007, to Sept. 29, 2017.  Past performance is no guarantee of future results.  Chart is provided for illustrative purposes and reflects hypothetical historical performance.

[1]   For detailed index methodology, please see https://asia.spindices.com/indices/strategy/sp-china-a-share-dividend-opportunities-index-chinese-renminbi .

[2]   Constituents were drawn from the combined universe of the S&P China A BMI and the S&P China A Venture Enterprise Index.  Eligible stocks must have a float-adjusted market cap no less than RMB 1 billion and three-month average daily value traded no less than RMB 20 million.  For factor portfolios except for small cap, a 10% buffer was applied on the size and liquidity thresholds that favor existing constituents.

[3]   Size is measured by a float-adjusted market cap.  Value is measured as the average z score of earnings-to-price, sales-to-price, and book value-to-price ratios.  Volatility is measured as the one-year realized price return volatility.  Momentum is measured by the z score of six-month risk-adjusted momentum, calculated as the price return over the past six months (excluding the most recent month) divided by the standard deviation of daily price returns during the same period.  Quality is measured as the average z score of balance sheet accrual ratio (BSA ratio), financial leverage and ROE.  Constituents of value, momentum, and quality portfolios are weighted by score-tilted market cap, subject to security and sector constraints such that the weight of each security is between 0.05% and the lower of 5% and 20 times its float-adjusted market-cap weight in the starting universe, and the maximum weight of any given GICS sector is 40%.  The small-cap and low-volatility portfolios are weighted by a float-adjusted market cap and inverse of volatility, respectively, without any security or sector constraints.  The low-volatility portfolios are rebalanced quarterly effective on the third Friday in March, June, September, and December.  The rest of the factor portfolios were rebalanced semiannually, effective on the third Friday in June and December.

[4]   Positive tilt to market capitalization denotes the tested portfolio had a large-cap bias compared to the benchmark.  Positive tilt to beta or volatility denotes the tested portfolio was less defensive.  Positive tilt to the price-to-fundamental ratio means the tested portfolio was more expensive than the benchmark.  Positive tilt to LT debt to capital and BSA ratio means companies in the tested portfolio had higher financial leverage and poorer earning quality, respectively.  Positive tilt to net margin or ROE means companies in the tested portfolio were more profitable.

[5]   Ung, Daniel and Luk, Priscilla (2016).  “What Is in Your Smart Beta Portfolio? A Fundamental and Macroeconomic Analysis.”  S&P Dow Jones Indices. Zeng, Liyu and Luk, Priscilla (2017).  “How Smart Beta Strategies Work in the Hong Kong Market”  S&P Dow Jones Indices.

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

Income Is Expensive but Don’t Wait for a Free Lunch

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Philip Murphy

Managing Director, Global Head of Index Governance

S&P Dow Jones Indices

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Those looking to convert risky assets into predictable income streams by purchasing bonds or annuities may be disappointed to learn how relatively little income they can acquire with a given level of wealth.  However, it is more constructive to accept capital market conditions for what they are rather than looking at this as an insurmountable problem.  While low rates equate to expensive income, the other side of the same coin is rich valuation of the stock market (driven by a number of factors but perhaps mainly due to low rates).  It is historically rare to have the free lunch of buying relatively cheap income with relatively high-valued stocks.  From around 1949 to 1966, capital markets did offer that precise bargain.  Stock valuations, as measured by Robert Shiller’s CAPE ratio, increased from between 9-10 in 1949 to a peak of over 24 in early 1966 (see Exhibit 1).  The 10-year Treasury rates moved from about 2.30% to about 4.75% over the same period.  Those who retired around  1965 who planned ahead and began buying income a little at a time, say 15 years before retirement, would have converted increasingly valued equites into increasingly cheaper (and therefore larger) predictable cash flows.

Unfortunately, free lunches are a rare treat.  Most of the time, stock valuations have been high when interest rates were low, and vice versa.  For example, in the early 1980s when rates hit all-time highs, the CAPE ratio sank well below 10.  You could have bought a lot of income with a given wealth level, but if your wealth was in stocks it was not a great time to sell.

Looking ahead, higher rates may coincide with lower stock valuations.  For those approaching retirement, timing income acquisition may be just as fraught as timing stocks.  On the other hand, buying expensive income with expensive equities may not be as poor a tradeoff as it first seems—particularly if implemented a little at a time through a methodical program.  Dollar cost averaging is a time-tested approach to wealth accumulation; why not apply the same technique to other long-term financial challenges like providing retirement income?

S&P Dow Jones Indices has an index series that represents a strategy of doing just that—dollar cost averaging into assets that mitigate the risk of future inflation-adjusted income.  It is called the S&P STRIDE Index Series, but the strategy it measures is not the only way to accomplish the same goal.  Bond laddering is another, and there are insurance-based solutions like annuities and guaranteed minimum withdrawal programs.  For 401(k) savers, laddering is not feasible and insurance products are not widely available.  However, many retirement plan sponsors are actively looking for solutions to facilitate an income goal as the ultimate mission of their plans.  If you are fortunate enough to have a retirement plan, that is half the battle.  If you have a plan but do not have income options, speak to your benefits department to encourage them to begin considering how to offer a retirement income program within the plan.

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