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Decomposing Recent Volatility Events Part 2

Assessing Single-Stock Risk in South African Indices

Spending Too Little In Retirement?

The Skew Is Not New

Can High Concentrations Lead to Equal-Weight Outperformance?

Decomposing Recent Volatility Events Part 2

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Berlinda Liu

Director, Global Research & Design

S&P Dow Jones Indices

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In my previous blog, we compared a daily inverse index to a “true short” and discussed the increasing vega exposure in the S&P 500® VIX® Short Term Futures Inverse Daily Index over the past couple of years. In this blog, we analyze how the mechanics of a VIX futures index, a low volatility environment, and various forces in the market may have contributed to the after-hour spike of VIX futures contracts on Feb. 5, 2018.

Rolling of VIX Futures Is a Double Edged Sword in VIX Futures Index Performance

The benchmark VIX futures index, the S&P 500 VIX Short-Term Futures Index, replicates a rolling futures position on the CBOE Volatility Index (VIX) using the two nearest futures contracts on VIX. That means that its inverse, the S&P 500 VIX Short Term Futures Inverse Daily Index, theoretically is buying the front-month futures and selling the second month’s futures on a daily basis. In a contango market, which occurs about 80% of the time in the history of the index (shown in Exhibit 3 in this post), this buying/selling can translate into positive carries in the long term. However, a huge jump in volatility and an inversion of the VIX futures curve could result in a double blow on the S&P 500 VIX Short Term Futures Inverse Daily Index and the exchange-traded products (ETPs) that track it.

VIX ETPs, Other Institutional Investors, and the After-Hour Spike in VIX Futures

VIX ETPs rebalance after market close once they get the target weights for the next business day. Even though the size of the VIX ETP market is small relative to the overall U.S. equity market, it is sizable relative to the VIX futures market. A recent research piece published by Goldman Sachs, “VIX: Q&A on the Trading Dynamics of ETPs,” estimated that the size of the VIX ETP market accounts for roughly 40% of open interest of the VIX futures market.

When volatility rises, market participants are economically incentivized to buy VIX futures: the inverse VIX ETP issuers may do so to reduce a short position that has become too large; the leveraged VIX ETP issuers may do so to supplement a long position that has not risen as quickly as the AUM of the ETP itself. Goldman Sachs research group estimated that the after-hour “vega to buy” on Feb. 5, 2018, exceeded 200,000 VIX futures.

It is worthwhile to note that institutional investors that have also employed short volatility strategies would likely need to buy VIX futures to cover their short positions. The same applies to the systematic strategies that may have had hedging triggered. The end result of these combined forces is an accelerated price spike in VIX futures contracts in extended trading hours (see Exhibit 1).

Low VIX Levels Increased the Probability of a 100% Jump

Finally, VIX had been hovering in the lower teens for quite a long time. The lower level of VIX futures also made an n-point move a higher percentage than it would be with higher VIX futures prices. For example, a 10-point jump would be a 100% return with the VIX level at 10, and a 50% return with the VIX level at 20.

In conclusion, several variables appear to have contributed to the recent events witnessed in the VIX space. The combination of capital flowing into inverse ETPs, the compounding power of daily inverse indices and their index-linked ETPs, systematic trading strategies, a low VIX environment, a jump in volatility, and an inversion of the VIX futures curve together led to an accelerated rally in VIX as demonstrated by the ultimate drawdown in the inverse version of the asset class. The key takeaway for market participants from this event is that volatility is a complex asset class and one that has various players interacting at different levels based on their own economic interests. Therefore, understanding the mechanics of VIX futures and VIX futures indices should be a starting point for any volatility market participant.

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

Assessing Single-Stock Risk in South African Indices

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Michael Orzano

Senior Director, Global Equity Indices

S&P Dow Jones Indices

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Investing in stocks can be risky. However, investing in a single stock tends to be far riskier than investing in a diversified basket of stocks. South African investors received a jarring reminder of this in early December, when Steinhoff International Holdings dropped more than 80% in the two days following the international retailer’s disclosure of accounting irregularities.

Mitigating the impact of these idiosyncratic risk events through the use of broad-based indices is one of the reasons that many market participants have turned to index-based investing over the years. However, all indices are not created equal when it comes to the extent of risk posed by single companies. Even among seemingly similar indices, it’s important to look under the hood to understand precisely how the index measures the market segment it seeks to represent.

South Africa’s large-cap equity indices provide an interesting case study in this. Over the past several years, the tremendous growth of Naspers has resulted in the company representing nearly a quarter of the market-cap-weighted FTSE/JSE Top 40. However, because the S&P South Africa 50 incorporates a single-stock cap of 10%, the influence of Naspers (or any other company for that matter) is reduced (see Exhibit 1).

The potentially devastating impact of a large portfolio holding sharply dropping in price is obvious in a general sense. However, Exhibit 2 provides a simple illustration of the quantitative impact for a range of hypothetical scenarios. For example, if a company represents 50% of an index and its price drops 75%, the impact on the index—holding all else equal—would be a loss of 37.5%.

While Steinhoff is a component of the S&P South Africa 50, the overall impact was mitigated by the company’s relatively small weight. Prior to the accounting disclosure, the company represented less than 2% of the S&P South Africa 50, so its 80% decline translated to a loss of roughly 1.4% for the index.

However, what if Steinhoff was much larger and had a 25% weight in the index? An 80% decline in a stock that represents 25% of an index would have resulted in a much larger 20% overall index loss. In light of recent events, perhaps now might be a good time to check how much exposure there is to any one company in your index.

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

Spending Too Little In Retirement?

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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Yes, you read that right.  You might not be spending enough in retirement.  It seems impossible after rigorously following savings plans during the course of your career in order to achieve that golden nest-egg to provide just what you need to retire.  However, a problem arises when “what you need to retire” might not be defined by the nest-egg you built.

People have advanced considerably in saving for retirement with the help of tools from the defined contribution industry.  Even without paying much attention, workers have been “nudged” not only into saving but “saving more tomorrow” by getting automatically enrolled in plans with escalating payments into saving accounts.  In fact, plan participants have become so good at saving for retirement that by the time they retire, all they know is how to save for retirement.  This commonly leads to much confusion when one day, at retirement, a new retiree has one million dollars (or however much) to spend.

Most people entering retirement have never had to manage that amount of money before, so it is meaningless.  In fact, it can create an illusion of wealth causing people to feel they have so much money that they just start spending – and they end up over spending.  The flip side of this coin is that people have been so beaten into a saving mentality that it is psychologically difficult to go into a spending mode.  This causes people to under spend in retirement and miss their goal of continuing to live a lifestyle equivalent to what was in their working years.

Recently experts Warren Comier, Executive Director at DCIIA (Defined Contribution Institutional Investment Association) Retirement Research Center, and Tim Kohn, Head of Defined Contribution Services at Dimensional Fund Advisors joined S&P Dow Jones Indices in this video to discuss how to provide better solutions that bridge the gap from saving to spending by focusing on retirement income.

The first step is to communicate income in a familiar way.  When retirees are thinking day to day about whether they can afford a cup of coffee or a certain car, they are not necessarily thinking in terms of income but rather about the current amount in their checking account.  However, by changing the mindset back into an income-like framework to project an amount of money to spend monthly, according to an “annual salary,” and showing how long it can last, it liberates retirees mentally to start spending money at a rational and intelligent pace.  This may help participants feel better about their move from accumulation (when saving for retirement) to decumulation (when spending through retirement.)

In the case where maintaining a standard of living in retirement is the goal, it is an outcome like a consumption level, or an income level or a withdrawal rate.  This creates a need to balance the trade-off between growth assets and appropriate risk management assets throughout a participant’s life cycle both during the accumulation phase and the decumulation phase.

The growth side is generally easy for managers to get right, (broadly diversified, low-cost, transparent), but the risk management side is more difficult since participants face market risk, interest rate risk and inflation risk in retirement.  Many traditional wealth-based programs only address the market risk by reducing equities in favor of short-term fixed income that creates a disconnect between the risk management framework and the goal.  The short-term fixed income only makes sense when exhausting the portfolio on something like a car, a boat or a big vacation since it will likely control the variability of the income for that purpose. However, most people will probably not spend their portfolio immediately in one or two years but rather may take decades to exhaust their funds.  So, they need to model interest rate risk and inflation risk to avoid spending too much or too little.

Communicating in the right income terms helps the cultural challenge associated with moving from a lifetime of saving to a lifetime of spending.  Behavioral finance can continue to help investors not just in the saving phase for retirement but in the spending phase by removing myopic loss aversion, framing and other jargon to clarify the shift in conversation from an account balance to an income stream.  By providing a proper benchmark and retirement income calculator that is tied to the underlying investment, participants may more easily understand what they can spend in retirement; and ultimately that’s what everyone wants to know – how much can I reasonably expect from my retirement savings throughout retirement?

 

 

 

 

 

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

The Skew Is Not New

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Craig Lazzara

Managing Director and Global Head of Index Investment Strategy

S&P Dow Jones Indices

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Market observers have noted that the S&P 500’s performance so far this year has been dominated by a small number of technology stocks.  This observation is certainly correct, although it’s fair to question the relevance of a statistic based on fewer than two months’ data.  What’s more important is to bear in mind that this is not unusual.  For most equity indices, skewed returns are the rule, not the exception.

One technical measurement of skewness is that a distribution’s mean is greater than its median.  Unlike in Lake Wobegon, where all the children are above average, in the real world of positively skewed returns, most stocks are below average.  Graphically, there’s a long tail to the right, as pictured here:

The chart covers a 20 year period, but we don’t need long time horizons to detect skewed results.  For the S&P 500, e.g., returns have been positively skewed in 23 of the past 27 years.  Results are similar for other markets.

Why should investors care about skewness?

If skewed returns continue for the balance of 2018, it would be unsurprising to see active underperformance and equal-weight outperformance continue as well.

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

Can High Concentrations Lead to Equal-Weight Outperformance?

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Tim Edwards

Managing Director, Index Investment Strategy

S&P Dow Jones Indices

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Assigning equal weights to each constituent, such as in the S&P 500 Equal Weight Index, historically would have offered material outperformance over capitalization-weighted benchmarks across a range of markets.  Earlier this year, we published a paper examining how this occurred.

There are several perspectives one can take, ranging from factor or sector exposures all the way down to the pattern of contributions from each individual constituent stock.  However, one of the most interesting aspects of equal weight outperformance is that it arises primarily not through the differences between equal and cap-weighted sector exposures, but rather through the consequences of equally weighting within each sector.

So, what is going on?  We suggest that successful competition within each industry provides a mechanism for outperformance within equal weight indices.

Within a competitive industry setting, if a firm secures an advantage and begins to outperform, then three things will likely follow in consequence.  The first is that market capitalization of that firm will likely increase, relative to its peers.  The second is that – supposing such outperformance continues – the related sector index will become more concentrated into the outperforming company.  The third and final consequence – assuming a high level of competitiveness – is that the peers of that company will find ways to catch up with the prior leader, and reverse the prior concentration.

These consequences should be observable through the relative performance of equal weight indices.  If the largest companies in a sector outperform their peers, then a capitalization weighted index will outperform an equal weight index.  If the smaller companies in a sector outperform, then the equal weight index will outperform.

High levels of concentration might therefore provide a potential indicator for the future outperformance of equal weight indices in highly competitive sectors, since unusually high concentration in a sector may indicate significant potential for smaller firms to catch up – either through restrictions (regulatory or otherwise) placed on the larger firms, or organically as those smaller firms act catch up with the leaders.

We test this idea by comparing the relative level of historical concentration in each sector to the subsequent performance of equal weight indices.  In particular, for every month from December 1995 to December 2016, we first calculate the percentile rank in HHI concentration for each of 10 S&P 500 sectors compared to its (monthly) history since 1990.   We then examine the relative total return of the respective equal weight sector index, relative to its capitalization-weight sector counterpart, over the next 12 months.  The chart shows the results, split by quartile of relative concentration:

Concentration Versus Subsequent Equal Weight Outperformance in S&P 500 Sectors, 1995-2017

As the chart shows, on average, the strategy of equally weighting within a sector appeared to have been most attractive when that sector was unusually concentrated.  With the increasing availability of products linked to equal weight sector or market indices, investors might therefore consider “backing competitiveness” by adopting equal weight strategies in sectors or industries that appear to be more concentrated than usual.

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