Indexology^® Blog

February ended the longest historical monthly winning streak of 15 months for the S&P 500 (TR) that lost 3.7%.  On a total return basis for the month, 10 of 11 sectors lost, which has only happened in 12 of 342 months or 3.5% of the time (all 11 lost together in 13 months for a total of 25 or 7.3% of months where 10 or 11 lost together.)  Energy lost 10.8%, the most of any sector.  It was the 10th worst month on record for energy since Oct. 1989, and its worst month since Sep. 2011.  Rising inventories and concerns on Chinese demand put pressure on the sector, especially on the smaller companies that may be less hedged.  Only information technology was barely positive, up 0.1%.

The biggest story in February besides the correction itself may have been volatility  that almost tripled.  The annualized 30-day volatility rose from 8.1% on Jan. 31, 2018 to 22.5% on Feb. 28, 2018, and is the highest since Feb. 19, 2016.  To put it in perspective, the average going back to Feb. 12, 1988 is 15.2% and the volatility has only been greater than 22.5%, the current level, in 12.5% of times.

While volatility has increased in many down markets, it may not be a bad thing and can provide some trading opportunities.  However, at this point, there may be some warning signs, particularly from the S&P 500 Bond Index, the corporate bonds of the companies in the S&P 500.  These bonds say a lot about the financial health of the companies in the S&P 500 since the performance (or conversely yields) of the bonds may be dependent on the credit rating and ability of these firms to make payments.  Given rising interest rates generally put pressure on the bonds, and the topic has been concerning for some time now, the S&P 500 Bond Index has already been negative in 4 of the last 6 months.  Perhaps even more importantly, the risk premium as measured by the monthly return of the S&P 500 TR minus the S&P 500 Bond Index was negative (in other words was a discount) back in August 2017 that showed pessimism in the market, despite a positive stock market return.  This is since when bonds outperform stocks it says investors may prefer to hide in the downside protection of the bonds rather than to participate in the upside of the stocks.  Additionally the record high optimism observed in Jan. 2018 could have been taken as a warning signal given the history of stock market performance after discounts follow high premiums.

And for a closer view of the past 3 years:

Does that mean one might want to completely sell stocks? Probably not, especially if one believes in long-term growth of the economy.  However, the risk premiums by sector can be one place to look for where to overweight or underweight in addition to other macroeconomic factors.  Right now every sector but information technology is measuring pessimistic, which is the broadest pessimism seen since Aug. 2015 when all sectors showed a discount.  Consumer staples, energy and real estate are showing notably big discounts that while bearish, are not necessarily bearish on the economy yet.  It is clear that the glass is half empty in energy from the inventory and Chinese demand concerns, real estate is one of the worst impacted sectors from rising rates, and consumer staples is basically a defensive play so when there is expected growth, the market may lean towards consumer discretionary.  Financials and information technology are the other two growth sectors to watch before worrying too much.

Lastly, looking at GDP growth, the dollar, interest rates and inflation, it seems that small-caps and mid-caps are better positioned than large caps now and that energy, materials, information technology and financials are better positioned than real estate, utilities and telecom.

U.S. REITS have been lagging broad U.S. equities. During the recent climb in 10-year Treasury yields from the 2018 low of 2.41% on January 2, to as high as 2.94% on February 21, the Dow Jones U.S. Select REIT Index declined 11.2%. Though we have found that REITS have generally fared well over full cycles of rising rates, periods of sharper increases tend to weigh heavily on the minds of REIT investors.

However, REITs with shorter-term lease durations—apartments, hotels/resorts, manufactured homes, and self-storage—have generally fared more favorably. Theoretically, these REITs should be less sensitive to interest rates since they can reprice their rental agreements more quickly. The performance of the Dow Jones U.S. Select Short-Term REIT Index[1] illustrates this concept well, falling a lesser 9.3% over the same period, while its counterpart, the Dow Jones U.S. Select Long-Term REIT Index, fell 12.3% (see Exhibit 1).

If we expand the data to include the full run of the two most recent spikes in rates, we see that the Dow Jones U.S. Select Short-Term REIT Index has outperformed benchmark REIT indices. The performance of the Dow Jones U.S. Select REIT Index has been somewhat insulated by its exclusion of net-lease REITs, which tend to have relatively high sensitivity to interest rates. For this reason, we have also included the S&P U.S. REIT, which includes net-lease REITs as an added comparison (see Exhibit 2).

The Dow Jones U.S. Select Short-Term REIT Index has significantly outperformed the broader REIT market over the long run, with modestly lower volatility. This effect seems to be a byproduct of the index’s less-severe drawdowns during periods of rapidly rising rates.

It may be a good time for REIT investors to consider the duration of their REIT holdings. The Dow Jones U.S. Select Short-Term REIT Index may offer beneficial risk/return characteristics when compared to benchmark REIT indices, particularly during periods of rapidly rising rates.

[1]   https://spindices.com/documents/education/talking-points-dj-us-short-term-reits.pdf

Continuing the theme of rising interest rates and following up from my last blog, “With all the News of Higher Interest Rates, Don’t Forget About Floating-Rate Debt,” bond laddering is a strategy that provides increased income and the ability to adjust the stream of income in a rising-interest-rate environment. The approach is to invest in specific maturity dates, or “rungs” of the ladder. For example, if you wanted to create a bond ladder today, you could buy bonds maturing in 2019, 2020, 2021, and so forth. The products used for such a strategy can vary, but are usually U.S. Treasury bonds, U.S. Municipal bonds, or corporate bonds.

S&P Dow Jones Indices has published many articles that address this topic. The educational paper, “Laddering a Portfolio of Municipal Bonds,” is a detailed piece that covers the construction and benefits of this kind of strategy.

To many people, the most important part of creating a bond ladder designed to preserve capital and build wealth in a rising-rate environment is buying individual bonds or defined-maturity ETFs.

However, it’s possible to keep a bond ladder intact by reinvesting that cash into a new longer-dated instrument. By rolling the proceeds into a longer-dated instrument, every time a shorter one matures, it’s possible to create a reliable income stream that may rise with interest rates over time.

Indices can be a helpful way to study the performance of a ladder strategy and the income producing result of the strategy in an increasing interest rate environment. In some cases, the index may have an investable ETF or ETP product issued against it, which gives an investors access to that segment of the market.

The indices in Exhibit 1 have been designed for use in laddering strategies.

Exhibit 1: Indices Designed for Laddering Strategies (Total Returns)

 For more information, please see these additional laddering articles:

Navigating Rising Rates: Municipal Bond Ladders by Matt Tucker

The Tactical Case for Bond Ladder ETFs by Matthew Forester

Fixed Income Laddering by Kevin Horan

Advisors Managing Interest Rate Risk With Municipal Bond Indices and ETFS by Shaun Wurzbach

Applying a Laddering Strategy to Preferred Portfolios in Canada by Phillip Brzenk

Gaining clarity around the future spending, or consumption, that an investor’s savings can support is critical in planning for retirement. Being armed with information about retirement preparedness can inform one’s decisions about savings rate, expense budget in retirement, and investment selections. A first step towards solving this challenge is to understand how much retirement income costs.

One way to visualize retirement income is as a string of cash flows that fund a retiree’s consumption—the “retirement income liability”. The objective for investors is to fund these cash flows from current and future savings. Each of these cash flows has a price that is known from today’s bond yield curve. For example, the interest rate on a 10-year zero coupon US Treasury bond can be used to infer the present value[i] of a cash flow 10 years from now.

This framework suggests two primary risks that increase uncertainty about the degree to which current savings can support the retirement income liability. First, since the present value of future cash flows depends on interest rates, the cost of the liability is sensitive to interest rate changes. For example, if interest rates go up, the liability cost will go down, and vice versa. In addition, retirement consumption is likely to be in goods and services that rise in cost with inflation. Higher inflation means today’s savings do not have the same purchasing power in the future.

The S&P Shift To Retirement Income and Decumulation (STRIDE) Index Series can help cut through the fog of uncertainty.[ii] STRIDE Indices define a retirement income goal of $1 of inflation-adjusted income for 25 years, i.e., the Generalized Retirement Income Liability or “GRIL.” This definition assumes an average life expectancy of 20 years, beginning at age 65, plus a five-year buffer to account for uncertainty about life expectancy. Using real interest rates taken from available Treasury Inflation-Protected Securities (TIPS), S&P discounts each future $1 and adds them up to compute the present value of the GRIL, as shown in Exhibit 1.

Chart is provided for illustrative purposes. Assumes that the first dollar of income is received at the end of the first year of retirement. Present value calculation assumes a hypothetical discount rate[iii] of 2%.

With this number, we can meaningfully translate a retirement account balance into expected future consumption. Dividing the current balance by the cost of income (the GRIL) provides an estimated annual income stream in retirement. This number is equivalent to the value, in real terms, that can sustainably be withdrawn each year for consumption during the retirement period.

These insights can help inform what an investment solution should look like. An investment solution integrated with the goal of retirement income should focus on reducing volatility in the ratio of account balance to cost of income, which reduces uncertainty in the income estimate. To learn more about how the S&P STRIDE Index Series incorporates a retirement income focus into its design, tune in for part 2 tomorrow.

Important Information

In response to the need for income-focused benchmarks within defined contribution plans, on January 11, 2016 S&P Dow Jones Indices (S&P DJI) launched the S&P Shift to Retirement Income and DEcumulation (STRIDE) Index Series.

The series features multi-asset class income-based indices tied to target retirement dates. Dimensional Fund Advisors worked collaboratively with S&P DJI to develop the glide path, inflation hedging, and duration hedging techniques used in these indices.

Disclosures

The S&P STRIDE INDEX is a product of S&P Dow Jones Indices LLC or its affiliates (“SPDJI”) and has been licensed for use by Dimensional Fund Advisors LP (“Dimensional”). Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); these trademarks have been licensed for use by SPDJI and sublicensed for certain purposes by Dimensional. Dimensional’s products, as defined by Dimensional from time to time, are not sponsored, endorsed, sold, or promoted by SPDJI, S&P, Dow Jones, or their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such products nor do they have any liability for any errors, omissions, or interruptions of the S&P STRIDE Index.

Dimensional Fund Advisors LP receives compensation from S&P Dow Jones Indices in connection with licensing rights to the S&P STRIDE Indices. It is not possible to invest in an index.

Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

[i] A ”present value” is how much a future sum of money is worth today.

[ii] To learn more about the S&P STRIDE Index Series, see S&P STRIDE Index Series Methodology, available at us.spindices.com.

[iii] A discount rate is the rate used to transform future cash flows into today’s dollars.

A recent stipulation by SEBI for the mutual fund industry outlines how to treat size classifications and suggests that funds need to be very explicit in their stock selection and fund categorization when it comes to stock sizes. SEBI laid down rules for categorizing funds based on component stock sizes and fund houses have to adopt the rules by the first quarter of 2018. Index providers in India have been providing size indices for many years but index selection by asset managers has tended to disregard these criteria in favor of more customized approaches. As investor attention in India has focused more on indices, the natural value that indices bring to investors has grown in importance. Indices provide transparency, rules and a clean structure to the investment landscape and the result can be beneficial for investors.

In India, the quality and design of indices has evolved considerably over time. With the partnership of S&P DJI with the BSE, for the first time the benefits of global indexing standards were brought to the local market. In the last four years alone, Asia index Pvt. Ltd (Asia Index) has launched more than 75 new indices ranging from size, sector, thematic and smart beta. Indices are designed to provide a range of investment choices and Asia index has striven to do just that. On the one hand we have the S&P BSE 30, a liquid investable gauge of the Indian stock market and on the other we also have the S&P BSE AllCap index which is a broad comprehensive index series covering more than 90% of the total market capitalization of the market and is modular with an ability to slice as per size, sector and industry. Similarly smart beta indices for low volatility, value and momentum and other factors are all offerings available to the India investor. Most recently, an ESG (environmental, social and corporate governance) index which selects stocks based on their ESG scores has been launched. Fixed income indices have been available from CRISIL for some time too and have been quite popular with investors.

While the use of indices is just beginning to take off in India, the rapid growth in the number of new index launches from various providers has grown exponentially, with the expectation that markets are maturing rapidly and demand for well-designed and indices will ratchet up. The world of indexing is constantly growing and evolving and the Indian index providers have geared up to match the global pace.