Indexology^® Blog

As of Dec. 18, 2017, the S&P GSCI is up 4.6% for the quarter, driven by petroleum, which is up 9.9% and makes up more than 59% of the index.

So far in the quarter, the S&P GSCI Crude Oil is up 9.8% and the S&P GSCI Brent Crude is up 12.7%. The difference in return is an indication of the level of availability of the commodity in the market. WTI crude, the benchmark for North America, is relatively underperforming Brent crude because of record-high levels in U.S. production. Meanwhile, Brent crude, the benchmark for crude oil production in Europe, Africa, and the Middle East, is being supported by OPEC’s rebalancing efforts and the shutdown forced by repairs of the UK’s most important pipelines.

While the spread between the two crudes has been widening since September 2017, it is important to note that it is not as wide as the spread reported at the end of 2016, when the S&P GSCI Crude Oil closed the year up 8.0% and the S&P GSCI Brent Crude closed up 28.5%.

In addition to the difference in returns, the two crudes are exhibiting different levels of backwardation and contango. Brent crude is in a state where its futures curve is sloping downward, generating a positive roll yield and an expectation that prices will rise, while WTI crude is in contango, with an upward sloping futures curve resulting in negative roll yield, along with an expectation that prices will fall.

When a company makes profit, it may choose to reinvest all of its earnings (common for growing stage companies) or pay back some to its shareholders in the form of dividends (for more mature companies). For market participants who seek a steady income stream and potential dividend reinvestment opportunities, dividend strategies can be one potential option.

Numerous academic and practitioner studies as well as empirical evidence have shown that, over the long term, dividend-paying stocks tend to outperform non-dividend-paying stocks and the broader market.[1][2] Furthermore, if a company is committed to paying dividends, we can reasonably think that the company is profitable, which is key for future capital appreciation.

One way to measure the attractiveness of an income-oriented strategy is its dividend yield. Companies with high dividend yield can be generally considered desirable if their fundamentals support a high payout ratio. This is because dividend yield alone only tells part of the story. We know from the dividend yield formula, computed as a stock’s dividend amount divided by its share price, that both dividend payment and share price influence yield level. All else equal, a high dividend yield coming from stable or increasing dividend payments is superior to the one stemming from declining price.

Since dividends are paid out in cash, the amount of distributable cash flow that a company holds should be considered when evaluating the sustainability of dividends. Distributable cash flow can be estimated from free cash flow, which is the excess cash generated by a company’s operating activities, excluding capital expenditures. When a dividend-paying company demonstrates positive or growing free cash flows, it is an indication that the company has the financial strength to fund its future payout, since its dividends are supported by sufficient cash. On the other hand, negative or decreasing free cash flows may signal insufficient cash flows for a company’s operational growth.

The recently launched S&P 500 Dividend and Free Cash Flow Yield Index combines dividend yield and free cash flow yield in the constituent selection process. Only sector leaders exhibiting both high dividend yield and free cash flow yield are included in the index. The index has demonstrated an attractive yield level, strong tilt to value characteristics, and attractive risk-adjusted returns compared with the S&P 500 (see Exhibit 1).

But did adding free cash flow yield help reduce the risk of dividends being cut? We looked at the dividend decrease or suspension by S&P 500 constituents for the last decade (2007-2016). The percentage of dividend reductions for the S&P 500 Dividend and Free Cash Flow Yield Index has been lower than that of the S&P 500 in 6 out of 10 years (see Exhibit 3). In 2009, the highest number of dividend cuts occurred in the stock market in over 50 years,[3][4][5] and the dividend investment strategy suffered the most as companies preserved cash to get through the financial crisis. However, we see that, overall, a company was more likely to sustain its dividend yield level when there were adequate free cash flows.

Our analysis of the combined high dividend and free cash flow yield characteristics shows that a durable dividend income could be achievable when the dividend yield is supported by high free cash flow yield, which will be discussed in coming blogs.

[1]   Ploutos. “Do Dividend Stocks Outperform?” 2016.

[2]   J. Siegel. “The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New.” 2005, pp. 127.

[3]   Seeking Alpha. “2009: A Bad, Bad Year for Dividends.” Jan. 7, 2010

[4]    Seeking Alpha. “Everything You Ever Wanted To Know About Dividend Cuts But Were Afraid To Ask.” Nov. 15, 2014

[5]    New York Times. “As Dividends Have Fallen, So May They Rise.” Jan. 8, 2010

Despite three interest rate hikes, record issuance, and a total market size climbing toward the USD 1 trillion mark, the dominating theme for loans in 2017 has been the massive amount of repricings that have occurred throughout the year. As detailed in an earlier blog post, leveraged loans pay a two-part coupon—a market-driven base rate plus a contractual credit spread. The accommodative market conditions (i.e., high demand and limited supply) have allowed issuers of bank loans to renegotiate the fixed component of their interest payment via repricing.

Generally speaking, the appeal of leveraged loans in a rising rate environment is the floating nature of coupons—as interest rates increase, the base rate (typically 30-90 day LIBOR) also increases, providing market participants with a way to minimize interest rate risk while also generating extra income. As expected, both one-month and three-month LIBOR have increased 60-70 bps throughout the year and sat at 1.47% and 1.59%, respectively, as of Nov. 30, 2017 (see Exhibit 1).

As mentioned, market conditions have allowed issuers to reprice a staggering amount of loans throughout the year (see Exhibit 2). As of Nov. 30, 2017, a total of USD 520 billion of leveraged loans had been repriced in 2017. Perhaps more surprising is that this figure includes nearly USD 130 billion of facilities that have been repriced twice this year. Given the size of the market at the start of the year (USD 850 billion as per the S&P/LSTA Leveraged Loan Index), that translates to over 45% of the total market. The month of November saw USD 79 billion in repricings—the second highest ever, following the unprecedented USD 100 billion of repricings that occurred in January.

Of course, the repricing impact has taken a toll on yields. Typically, repricings result in a reduction of credit spreads from 50 to 150 bps. For the first 10 months of 2017, repricing activity averaged 85 bps. That number fell to 64 bps for November, as there was less opportunity for spread savings, given the large repricings that had already occurred earlier in the year. Over the course of 2017, repricings have dropped the average weighted credit spreads of the S&P/LSTA Leveraged Loan Index from L+460 to L+382 (see Exhibits 3 and 4).

So, have repricings run their course in the loan market and, if not, how much more room is there for deals to reprice further? That all depends on market technicals (i.e., supply-demand imbalance).

The current expectation is for continued interest rate hikes through 2018, which should keep demand up for floating-rate assets. Additionally, as long as institutional investors are sitting on cash, loan issuers should benefit. Given the choice between cash returns or a repricing, institutional investors will continue to be accommodative to loan issuers.

As of Dec. 15, 2007, the S&P/LSTA U.S. Leveraged Loan 100 Index was up 3.07% YTD, while the broader S&P/LSTA Leveraged Loan Index had returned 3.88% (see Exhibit 5).

The discussions on the merits of carbon awareness investing are evolving and highlighting a desire to shift from the current data-driven carbon emission framework to a more sophisticated and risk analysis-driven, 2 degree pathway paradigm. The shift has been spurred largely by the Financial Stability Board (FSB) and recommendations from its Task Force on Climate-related Financial Disclosures (TCFD). At the Responsible Investor Americas Conference in early December, the implementation and the impact of the TCFD recommendations were a heavily discussed topic, as they could prove to be a game-changer in carbon awareness investing.

The TCFD was created in 2015 by the G20 Finance Ministers and the Central Bank Governors, headed by Michael Bloomberg and given the goal to create a climate-related disclosure framework that will aid the three major groups who are involved in understanding climate-related financial risks—corporations, investors, and regulators. Its report was released in June 2017 and is expected to prove instrumental in laying the groundwork and framework to help market participants understand the risks and opportunities posed by the transition to a low-carbon economy.

TCFD Recommendations

The TCFD recommendations call for greater climate-related disclosure and information in a corporation’s governance, strategy, and risk management processes and the implementation of standardized metrics plus targets. The materiality principle assessment is encouraged in the strategy and metrics and targets sections. The TCFD’s overarching goal was to focus on the financial impact of climate-related risks and opportunities on an organization rather than the impact of an organization on the environment (Exhibit 1). This latter effort is synonymous with impact measurement, which is an outward assessment aiming to quantify the impact of a company in regard to its environmental consequences. As discussed in my previous blog, the endeavor itself is honorable but presents a host of considerable challenges. Global companies have a multitude of businesses and can find themselves making numerous products—some that are deemed positive and others deemed negative. An attempt to arrive at an overall score that quantifies such an impact can be difficult, problematic, and unreliable at best.

TCFD Key Takeaways

As the TCFD’s report encourages companies to make disclosures, it is hoped that these disclosures will end up in mainstream integrated financial reports rather than in sustainability reports, whereby audit committees and senior executives will then get involved (Exhibit 2). In addition, the task force encouraged the use of scenario analysis, whereby corporations can use forward-looking information, with the 2 degree scenario as the common reference point. The TCFD realizes that widespread adoption of its recommendations is critical and the momentum is there, as evidenced by the recent EU High Level Expert Group on Sustainable Finance announcement that the TCFD recommendations will be integrated into EU policy. More than 100 companies with a combined market cap of approximately USD 3.5 trillion and financial institutions responsible for USD 25 trillion in assets have stated their support for the TCFD recommendations following their launch in July 2017.[1]

The TCFD says that asset owners have a crucial role to play in influencing better disclosure, as they hold the power of mobilizing assets in the investment value chain. The TCFD is sanguine that its recommendations implementation path will gain further momentum and envision the following milestones over the next five years, as climate-related risks and opportunities reporting takes hold.

[1]   TCFD Press Release, June 29, 2017, Final Recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) Help Companies Disclose Climate-related Risks and Opportunities Efficiently and Effectively, available at https://www.fsb-tcfd.org/wp-content/uploads/2017/06/Press-Release-Final-TCFD-Recommendations-Report-Release-29-June-2017-FINAL-IMMEDIATE-RELEASE-UPDATED-SUPPORTERS-LINK.pdf.

In a recent study published in the Financial Analysts Journal, Ang, Madhavan, and Sobczyk (2017)[1] highlighted that using regression-based factor loadings to measure managers’ factor exposures, even when conducted on a rolling basis, can be misleading due to excessively smoothed coefficients, given that active managers adjust their exposures dynamically. The authors argued that holdings-based attribution offers more insight, and they used the actual holdings of mutual funds to analyze the contribution to active returns by factors.

With that in mind, in a previous post, we performed a holdings-based performance attribution to highlight that the improvement in relative performance of actively managed large-cap mutual funds stemmed entirely from the stock-selection effect (excess returns of 1.75%), demonstrating their abilities to pick winning stocks. In this follow-up post, we use the same holdings of the managers to take a closer look at their active factor exposures relative to the S&P 500 and their contribution to active return.[2] This risk-based attribution analysis complements our prior Brinson performance attribution analysis, providing a holistic picture on the sources of excess returns.[3]

During the 12-month trailing period ending June 30, 2017, large-cap active managers, on average, were underweight to value, dividend yield, and size factors, and they had higher positive tilt to beta, momentum, and leverage factors (see Exhibit 1). In addition, we observed lower negative tilt to price volatility and earnings variability factors within the same group of managers.

Earnings variability and leverage are measures often used as proxies for the quality factor. Taken together, large-cap managers were, therefore, more exposed to lower quality and higher volatility during the 12-month period studied. This generalized behavior comes as no surprise, as the equity market during the same period has been ripe for risk taking, with lower quality outperforming higher quality in the large-cap space.[4]

In terms of the impact of managers’ factor bets on their average active return, we can approximate that not all exposures have been handsomely compensated. For example, dividend yield, revenue/price, and size had negative monthly average returns to the factor, which has resulted in an overall positive factor impact (see Exhibit 3).[5] Beta[6] has also been a rewarding factor for those managers seeking broad market exposure. It has been the best-performing factor, and large-cap managers on average have been overweighting their beta exposure.

However, the average monthly return to other value factors such as book/price and earnings/price have been positive and the underweight to those factors have detracted from the average portfolio active return. Higher average exposure to volatility, momentum, and to earnings variability factors have also detracted from excess returns.

Taken all together, we now have a fuller picture and insight on what has worked for actively managed large-cap mutual funds and what hasn’t over the 12-month period studied. Judging by the longer-term historical SPIVA^® results, large-cap U.S equity remains a challenging asset class for an average active manager to beat and to do so consistently. It remains to be seen if the results we witnessed can be repeated in the future.

[1]   Ang, Andrew, A. Madhavan, and A. Sobczyk, “Estimating Time-Varying Factor Exposures,” Financial Analysts Journal. Volume 73 Number 4.

[2]   We use the Northfield US Fundamental Risk Model to estimate the managers’ factor exposures.

[3]   Brinson attribution and risk-based attribution are mathematically and conceptually different enough that they can potentially produce different results. For more illustrative examples, refer to https://insight.factset.com/brinson-and-risk-based-performance-attribution-disagree

[4]   Based on the total returns of the S&P 500 Quality Index (14.79%) versus the S&P 500 Quality – Lowest Quintile Index (17.44%) from June 30, 2016, to June 30, 2017.

[5]   Factor impact is reported as the geometrically compounded return of monthly average active exposure * monthly factor return.

[6]   Beta here refers to the CAPM beta, where the market is represented by the general Northfield universe comprising approximately 5,000 U.S. companies.