Indexology^® Blog

Subscribers to our European dashboard will know that October was a broadly positive month for the region’s equity markets; the S&P Europe 350 posted a 1.66% total return, while nearly every equity strategy in the region gained.  Additionally, the S&P Europe 350’s closing price level of 1,600 for October brought the benchmark to within touching distance of its record month-end close of 1655, set over a decade ago.

Most European market participants will view this news as cause for celebration, but technical analysts may not.  Exhibit 1 shows that some of the most substantial drawdowns in the S&P Europe 350 have come after the index ended the month above 1,600.  History therefore suggests that 1,600 may be a “resistance level”—the index has closed above this level on several occasions, but has not managed to stay above it for an extended period.

However, there are indications that the S&P Europe 350 may be better equipped at present to do just that.

Exhibit 2 below shows the historical sector weights in the S&P Europe 350.  Prior to the precipitous drawdowns at the start of the century, the information technology sector obtained a relatively large weight courtesy of its substantial returns (orange circle); in the 24 months ending in August 2001, it posted a 278% price return—235% higher than the average for the other sectors.  Six years later, the weight of the industrials sector (blue circle) grew in the two-year period leading up to the Global Financial Crisis as the sector posted a price return of 97%, 53% higher than the average for the other sectors. In other words, the period leading up to the previous highs was dominated by extreme performances in a few sectors.  With more exposure to these sectors, the S&P Europe 350 was more heavily affected when trends reversed.  In contrast, recent returns have not been driven by any specific part of the market (or at least not as much)—only 29% separated the best 24-month sector price return from the average of the rest of the market as of Oct. 31, 2017 (excluding real estate).

In contrast, price returns from October 2015 to October 2017 were not been driven by any specific part of the market (or at least not as much)—only 29% separates the best sector return from the average of the rest of the market (excluding real estate).

Although upcoming events may conspire against the entire market, if the S&P Europe 350 is able to maintain its current form without suffering from the drawdowns observed historically, perhaps we will come to view 1,600 as a new support for this index.

During a recent retreat to the Blue Ridge Mountains, I picked up a copy of Outside Magazine’s 40^th 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…

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.

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.