Indexology^® Blog

Consider this thought experiment: You “know” that 499 of the companies in the S&P 500^® will return exactly 5% next year. One will return 100%. You have no way to determine which stock will be the big winner, or to know or infer anything about its characteristics. You can invest in either a cap-weighted S&P 500 index fund, or an equal-weighted S&P 500 index fund. What should you do?

We can begin by noticing that 120 of the 500 issuers in the S&P 500 are weighted at more than 0.20%—i.e., they have a higher weight in the cap-weighted index than in its equal-weighted counterpart. 380 issuers are weighted more heavily in equal-weight. We face a binomial choice—either equal-weight or cap-weight—and the “success” of that choice will be determined entirely by which index has a relatively higher weight in the one stock that’s up 100%. Since we are completely agnostic about the stock in question, choosing the equal-weighted index gives us a 76% probability of success.

Our example, of course, is artificial for any number of reasons, but it does illustrate an important truth: positively skewed returns favor equal-weight indices. Anyone who’s read a prospectus knows that past performance is no guarantee of future results. But past performance has indeed taught us two key lessons:

• Historical gains in equity markets have been driven by a relatively small number of stocks.
• The identity of these stocks is unknown—and generally unknowable—in advance.

The first point—the skewness of market returns—is clear in historical data. In 23 out of the past 27 years, the median stock in the S&P 500 has underperformed the return of the average stock. We see similar results in other markets. And if the second point were not true, we would not observe consistent underperformance from active managers.

These two points help us to understand a third:

• Equal-weight indices have demonstrated long-term outperformance over their capitalization-weighted equivalents.

To be sure, equal weighting does not always lead to success. For example, 2017 was an outlier, as the S&P 500, driven by a handful of large technology stocks, outperformed the S&P 500 Equal Weight. But the equal-weighted index has outperformed in 16 of the past 28 years, by an average margin of 1.5% annually. One reason for this record is the ability of equal-weight indices to take advantage of the positive skew in stock market returns.

After the Central Economic Work Conference (CEWC), specific plans and targets have been set for China’s economy. What are the investment opportunities followed the CEWC?

Investment outlook

To achieve high-quality development, the government will promote consumption and private investment to drive growth. Rural reform targeting to alleviate the poverty such as restoring land use rights to farmers could also unlock rural land wealth of US$20trn and hence boost rural consumption.

The government has recently selected 31 central and local SOEs as the third batch of the mixed ownership reform pilots program. SOE reforms, especially SASAC (State-owned Assets Supervision and Administration Commission of the State Council) reform, will accelerate in 2018.

New energy and eco-friendly firms will gain from anti-pollution initiatives. “China going green” is a government-led initiative for investment in the medium term. Investment in rural infrastructures (roads, access to water, power and Internet, etc.) and industries will likely emerge as a new growing area of fixed asset investment.

S&P China 500 Index consists of 500 largest and most liquid Chinese companies listed globally. It covers almost all the potential China-related investment opportunities. Broad based strength in Chinese equities propelled the S&P China 500 to a 44% total return for the year of 2017. The index had notably consistent performance during the year as well recording positive returns in all 12 months.

Benefited from its diversification in markets and sectors exposure, S&P China 500 has demonstrated better risk-adjusted returns (Figure 2). During the period from 31 Dec, 2008 to 31 Dec, 2017, the S&P China 500 generated an annualized return of 13.0% and Sharpe ratio of 0.59, both are the highest among the major China indices.

¹  ChinaDaily, 21 Dec 2017. http://www.chinadaily.com.cn/a/201712/21/WS5a3af4aea31008cf16da2822.html

²  ChinaDaily, 20 Dec 2017. http://www.chinadaily.com.cn/a/201712/20/WS5a3a3b4ba31008cf16da279a.html

For many years, active fund managers and institutional investors have often used a factor-based approach either to strategically construct portfolios or to tilt their portfolios toward well-known risk factors, such as low volatility, value, momentum, dividend, size, and quality, to capture the factor risk premium. Investors seeking to identify skilled active managers look to dissect fund performance into returns generated from factor exposures and alpha that is attributable to fund manager skill, which in turn should affect fund flows.[1]

An analogy[2] used to explain this concept associates factors to nutrients and stock returns to food items. Different food items (such as pulses, milk, vegetables, bread, burgers, pizza, etc.) contain nutrients (such as carbs, vitamins, proteins, fats, minerals, etc.) in varying proportions. Similarly, a stock’s risk/return characteristics can be thought of as being explained by different risk factors. A factor index looks to bucket stocks with similar risk/return characteristics. Extending this analogy, different individuals (e.g., an athlete versus someone with a desk job) have different nutrient requirements, therefore they would consume different combinations of food items. Similarly, investors with different risk appetites would allocate accordingly to different factors to generate returns. For example, an investor who is keen on a low risk or defensive portfolio would potentially look to allocate a higher proportion to low volatility and quality factors, whereas as an aggressive investor might look to add exposure to value and size (small-cap) factors. Factor-based investing provides a route to objectively capture inexpensive companies (via value factors) or companies with robust balance sheets and steady returns on equity (via quality factors).

The first model that initiated the conversation on factor investing was the Capital Asset Pricing Model (CAPM) suggesting that a single factor—market exposure—drives the risk and return of a stock. The CAPM suggested that returns that were unexplained by the market factor were idiosyncratic or company-specific drivers. Gradually, the Fama-French Model looked to account for additional factors such as size and value, in addition to broad market returns. Follow-up research by Carhart and Pastor-Stambaugh yielded two new factors, viz momentum and liquidity, respectively. As academic research evolved, newer factors, such as growth, quality, dividends, and volatility, were thought to have attributed to stock returns as well.

Exhibit 1: The Evolution of Factor-Based Investing

Source: Fidelity Investments.[3] Chart is provided for illustrative purposes.

Factor-based investing can be implemented passively with the aid of factor indices aiming to provide exposure to specific factors, following rules-based methodologies, which tend to be more cost effective and transparent than actively managed portfolios. Globally, smart beta products have gained tremendous popularity with smart beta equity ETF/ETP assets, seeing an AUM growth of over 31% CAGR to USD 644.40 billion for the five-year period ending in September 2017. Smart beta ETFs/ETPs account for almost 19% of all equity ETF/ETP AUM as of September 2017.

Exhibit 2: Market Cap Beta Versus Smart Beta

Source: ETFGI.[4] Chart is provided for illustrative purposes.

Factor indices are not designed to replace market-cap-weighted indices. Broad-based or market-cap-weighted indices represent the entire investable opportunity set for market participants. They aim to capture long-term equity risk premium with low portfolio turnover, high trading liquidity, and large investment capacity. Factor indices look to capture targeted risk premia following a rules-based and transparent index methodology. Not only is the stock selection for these indices based on specific factor criterion, but the stock weights are also related to the stocks’ factor scores, which are used to create factor tilts within the index portfolios. In contrast to passive products based on broad-based indices, factor-based strategies can provide an opportunity for market participants to express their active views away from market-cap-based portfolios. Thus, like active funds, factor performance should be evaluated in the long run against a market-capitalization-weighted benchmark.

Please refer to Factor Performance Across Different Macroeconomic Regimes in India for more information on this research paper.

[1]   Barber, B., Huang, X. and Odean, T. (2017). What Risk Factors Matter to Investors? Evidence from Mutual Fund Flows. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2408231&rec=1&srcabs=2038108&alg=1&pos=9

[2]   https://www.blackrock.com/es/literature/brochure/factor-investing-unlocking-drivers-of-return-en-lai.pdf

[3]   https://www.fidelity.com/bin-public/060_www_fidelity_com/documents/brokerage/overview-factor-investing.pdf

[4]   https://www.researchpool.com/download/?report_id=1570482&show_pdf_data=true

Investment strategies featuring the quality factor could benefit from current trends in consumer spending

• Retail sales surged by more than 5% in December, eclipsing previous highs.
• Consumer spending could be further bolstered by recently enacted federal tax cuts.
• Investment strategies that include the quality factor could benefit from higher consumer spending.

Advance estimates of US retail sales for December 2017 displayed vibrant year-over-year growth of 5.64%, according to the US Census Bureau.¹ The most recent report, released on Jan. 12, covers sales ex-food, automobiles, gasoline and building materials. December sales growth was at its highest level since peaks in 2011 and 2014, and was above the trend seen since early 2011 — further highlighting strength in consumer activity.

Federal tax reform could benefit consumer spending

Looking forward, I believe that strength in consumer spending is likely to be underpinned by the recently passed federal tax cut, dubbed the Tax Cut and Jobs Act. (Harsh winter weather may be a caveat, however.) In fact, a number of companies have already announced employee bonuses and higher wages in the wake of this legislation.

Robust consumer spending is typically a friendly factor for the equity market, and may provide a reason to maintain equity exposure, in my view, despite high equity valuations seen over the past year and the lack of any significant market correction. On a total return basis, the S&P 500 Index closed higher in every month of 2017, while its forward price-to-earnings (P/E) ratio is at 18.6 — a level last seen in the technology bubble of the early 2000s.²

Quality factor exposure can potentially harness strength in consumer spending

Investors who want to gain exposure to high-quality companies that can benefit from higher consumer spending may want to consider the quality factor. Consider, for example, that the S&P 500 Quality Index has 27% exposure to the consumer-focused sectors, with 12% of its holdings in consumer discretionary shares and 15% in consumer staples.² Although the consumer staples sector can at times be viewed as defensive, this isn’t always the case. Consumer staples holdings within the S&P 500 Quality Index include Costco and Walmart, which are both influenced by consumer spending.

Other key exposures rest in industrials (23.5%) and information technology (22.5%).² These two sectors have the ability to benefit from strong economic trends as well. Moreover, within information technology, the S&P 500 Quality Index holds Visa and MasterCard, with just over a combined 9.0% exposure.² Both of these companies can benefit from strong consumer spending via their transaction-based businesses, which facilitate consumer purchases.

One of the potential benefits of the quality factor is the selection of stocks that have strong balance sheets. In this case, the S&P 500 Quality Index selects stocks based on return on equity, leverage and earnings quality via accruals.

1 Source: The US Census Bureau, Jan. 12, 2018

2 Source: Bloomberg L.P., as of Jan. 15, 2018

With 2017 in the rear view mirror, we can look back and observe that short VIX strategies rank as one of the most profitable strategies of the year. The S&P 500^® VIX Short-Term Futures Inverse Daily Index returned 186.39%, and selling VIX futures has become a popular income-generating strategy. 2017 was also a year marked by an extraordinary level of low volatility. VIX has been hovering around 10 and dipped below 10 more than 50 times; on Nov. 3, 2017, VIX posted its all-time low   of 9.14.

Contrary to the traditional “buy low, sell high” investing principle, in VIX trading, low volatility encourages more selling, rather than buying, on VIX futures, which is counterintuitive given the often-discussed, mean-reverting property of VIX.

There are two factors market participants need to consider when confronting this mystery.

First of all, VIX displays local mean reversion. That is, it tends to return to its short-term local mean, rather than to its long-time average. Exhibit 1 shows VIX numbers, with 126-, 252-, and 1,260-trading-day averages. We can see regime shifts of VIX over its history. The long-term mean (in this case, five-year average) has very little indicative power on the current VIX level. As VIX tends to rise much faster than it falls, in low VIX markets, such as in 2013, 2014, and 2017, the spot may remain below its long-term mean for extended periods.

Second, we need to understand that VIX futures indices and their index-linked investment vehicles provide short exposure to VIX futures, not the spot. A key concept for any futures contracts, not just VIX futures, is the futures term structure, since the futures curve shape dictates whether rolling futures over time incurs cost or benefit. Futures are in contango when the futures term structure is upward sloping, meaning the futures prices are more expensive than the spot. Futures are in backwardation when the futures term structure is downward sloping, meaning the futures prices are less expensive than the spot (see Exhibit 2).

Although the VIX spot is somewhat mean reverting, holding a long position in VIX futures over the long term tends to produce losses, because the VIX futures term structure is usually in contango, as market participants generally associate more uncertainty with longer time horizons. However, in a stressed market where immediate risk is perceived by most market participants, the VIX futures curve tends to flip into backwardation.

To highlight, we can use the widely followed S&P 500 VIX Short-Term Futures Index as an example. It rolls continuously from the first-month futures to the second month. Exhibit 3 shows the price difference of these two contracts starting on Jan. 3, 2005, calculated as the second-month VIX futures price minus the first-month VIX futures price. Among these 3,272 trading days, contango occurred on 2,718 days (83%) between the first- and second-month VIX futures. Given that approximately 5% of the portfolio is rolled on a daily basis, the average daily roll cost is 29 bps.

This roll cost may seem minor on a standalone basis, but its cumulative impact on VIX futures performance is significant. If VIX remains unchanged for a year, the index can potentially lose about half of its value in the continuous daily roll process.

Therefore, we need to take into account that VIX spot tends to revert to its short-term mean, and the current low volatility environment may persist until a regime shift. When VIX is low and the market is calm, the VIX futures curve tends to be in contango, which encourages shorting VIX futures strategies, as we witnessed in 2017.