Indexology^® Blog

In a prior blog, we highlighted that the recent Responsible Investor Europe Conference 2018 gave attendees the sense of a coming of age in the environmental, social, and governance (ESG) movement that could potentially portend a future filled with a greater sense of urgency and call for action in the sustainability world. As noted previously, the drivers behind this heightened sense of urgency stem from a changing political climate that could be potentially less favorable for global ESG issues, the Taskforce on Climate-related Financial Disclosures (TCFD) recommendations on disclosure implementation, and landmark legislative proposals that have been put forth by the European Commission.[1]

The question then arises: What does this call for urgency and action mean for future developments in ESG investing? Here we identify several key themes that we believe will garner more attention in the coming months, extending well into 2019.

1. Proliferation in ESG-driven investment products on the active and passive fronts to satisfy growing demand, especially from Millennials: The compound annual growth rate (CAGR) of ESG-specific assets rose 23% from 2014 to 2016, compared with the industry average CAGR of 5%.[2] To meet this continued demand, there will be more ESG-related investment products coming to market, as product sponsors continue to build out and extend their suite of ESG offerings.[3] While many products will incorporate standard ESG exclusions, market participants should also expect to see indices and products that incorporate more forward-looking data that follow TCFD recommendations. The Church of England’s Pension Board also announced plans to develop its own index backed by the Transition Pathway Initiative’s analysis of 105 of the world’s largest and highest-emitting public companies across the coal mining, electricity, and oil & gas industries.[4]
2. S-related issues will continue to be at the forefront: According to a new paper released by the Harvard Kennedy School, “Money, Millennials and Human Rights: Sustaining ‘Sustainable Investing’,” the S in ESG investing is “by far the weakest” element, and the S subcomponent yields the lowest correlation in a comparison of S scores across different rating providers. It recommends that the United Nations Guiding Principles on Business and Human Rights serve as the basis of what analysts, rating providers, and investors measure when it comes to the S aspect. The paper cites an NYU study that revealed that only 12% of S-ratings products target investors as the primary audience, versus 97% and 80% of E- and G-ratings-based products, respectively. Owing to this void in the market, we expect to see more S-related investment products coming to market.
3. More research on ESG and materiality in a push to classify ESG indicators from “non-financial” to “extra-financial”: In order to integrate ESG factors into the financial analysis process, there will have to be a rethink in the financial industry, leading to a mind shift in classifying ESG information away from the term “non-financial,” which has negatively affected ESG adoption by analysts and portfolio managers in the past. In order to get to the goal of greater acceptance, there will need to be more continued in-depth research examining ESG and materiality. The classification of ESG data as “non-financial” can evolve and take on more significant financial interest to investors and become more aptly “extra-financial.”

There is ample evidence that the three trends are already starting to take shape, with more product sponsors filing for ESG-related investment products. Going into the second half of 2018 and into 2019, we are confident that the above trends will come to fruition, as ESG participants feel the pressure to integrate and implement ESG strategies as it transitions to the mainstream.

[1]   The European Commission has confirmed its first four legislative proposals to spur sustainable finance in the region, covering green definitions and taxonomy, investor duties, retail investing, and benchmarks. In reference to the fourth pillar, the European Commission plans to use a delegated act to create a new category of benchmarks focused on climate mitigation. The first will be a conventional low-carbon benchmark, which will serve to “decarbonize standard benchmarks” by selecting stocks with lower emissions. For those investors that want to be 2 degrees Celsius compliant, the second benchmark—which is described as “impact” focused—will be more ambitious and will seek to meet the Paris Agreement whereby a company’s carbon savings outstrip its carbon emissions. European Commission: Press Release Database “Sustainable finance: Making the financial sector a powerful actor in fighting climate change.” May 24, 2018.

[2]   Kim, Crystal. “Could ESG Become the Wrapper for All Investing?” Barron’s. June 23, 2018

[3]   Vanguard recently announced that it had filed for two ESG exchange traded funds (ETFs)—the Vanguard ESG U.S. Stock ETF and Vanguard ESG International Stock ETF. These indices will exclude controversial industries such as weapons, fossil fuels, etc., in addition to incorporating additional screening for criteria such as diversity, human rights, and anti-corruption. Vanguard. “Vanguard Files For Two New ESG ETFs.” June 27, 2018.

[4]   The Church of England. “Archbishop of Canterbury’s comments at Transition Pathway Initiative summit.” July 2, 2018.

By the close of trading on Thursday, July 26, 2018, shares in Facebook (FB) traded down almost $99 billion, or 19% of their market value. Despite FB’s beginning weight of 2.16%, the S&P 500^® was almost flat, losing 0.30% on the day. I suspect you will not hear much about this from those who attempt to create an association between indexing and bubble building. However, for those looking to understand the market, as well as potential changes brought on through the adoption of indexing as an investment strategy, yesterday’s trading in FB shares offered several things to think about.

At the close of July 25, 2018, the S&P 500 included 2,398,606,000 FB shares, substantially all of the company’s shares outstanding. Their value of $217.50 each gave FB a market value of $521.7 billion. At the close of July 26, 2018, the S&P 500 still included the same 2,398,606,000 FB shares. The index did not “sell”, or “drop” in index parlance, one share of FB stock. Nevertheless, by the close of trading, FB was valued at $176.26 per share, or about $422.8 billion for the whole company.

On July 26, 2018, index funds that track the S&P 500 would have no need to sell FB shares, unless they were managing cash flows out of their funds. However, if they were engaging in such trading, they would likely sell proportionate amounts of all stocks in the S&P 500, not only FB. Therefore, if index funds were predominantly responsible for the dislocation in FB shares, the overall market would have sold off to a similar extent.

After the fact, some may draw the conclusion that FB was overvalued. While possibly true, it would not be the most helpful lesson to draw. When the company warned about slowing revenue and contracting margins, it was new information for shareholders to digest. If investors had overvalued the shares on their way up, it was not because of cap-weighted index funds. Those who estimate company value had been overly optimistic and needed to correct their forward-looking assumptions. In other words, active investors set the share price. Investing in market cap-weighted index funds does not create valuation dislocations in individual stocks or bubbles in the market in general. The evidence lies in Facebook

On Friday morning the GDP (Gross Domestic Product) for Q2 2018 is set to be announced, and the consensus estimate from the Wall Street Journal survey of more than 60 economists is at 4.1%, the highest (actual) growth since Q3 2014.  Although forecasts greatly vary this quarter, the main factors likely influencing growth are tax policy, retail sales, international trade and manufacturing shipments.

While U.S. GDP growth is beneficial for stocks in general, the growth has been better for small caps than for large- or mid-caps.  On average for every 1% of GDP growth, the S&P SmallCap 600 has risen 5.2%, while S&P MidCap 400 and S&P 500 have risen a respective 4.9% and 4.0%.  Within small caps, the financials, health care and energy sectors have risen most with growth, gaining on average 6.9%, 6.4% and 6.3%, respectively for every 1% of GDP growth.

Although in small caps, financials have delivered 50 basis points more of return than health care from each 1% of GDP growth on average, the financial small cap premium is by far the most sensitive to GDP growth.  For every 1% of GDP growth on average, small cap financials have returned 2.4% more than large cap financials.

One contributing factor for the relatively large financials small cap premium is the percentage of revenues that are generated domestically from the small caps versus large caps.  The small cap financials generate about 95% of revenues from the U.S., 17% more than the large cap financials.  The result is the small cap premium in financials is 10.6% year-to-date through July 26, 2018.  While all 3 industry groups of the small cap financials outperformed their large cap counterparts, the small diversified financials outperformed most by 13.5%, just ahead of the small cap outperformance by insurance of 12.8%, and more than the 8.4% premium of small banks.

Within the diversified financials, the small cap premium was greatest from the consumer finance industry that may be attributed to strong consumer spending that accounts for more than two-thirds of U.S. economic activity, and is likely being driven by lower taxes and a robust labor market.  Similarly, small consumer staples have been more greatly benefiting than their large cap counterparts, outperforming by 16.6% YTD.  Also contributing to the small cap premium in financials is the life and health insurance sub-industry and the insurance broker sub-industry, with respective small over large performance of 28.3% and 24.3%.  This goes along with the small health care companies have been outperforming their large counterparts significantly this year by an impressive 31.3%.

As U.S. GDP growth accelerates, small cap stocks may continue to outperform large caps, but only if there is quality as in the S&P 600.

Given our recent announcement upgrading Saudi Arabia to emerging market status, it seemed like an apt time to delve a little deeper into the index country classification process and the criteria used to evaluate the status of markets here at S&P Dow Jones Indices (S&P DJI). At the risk of stating the obvious, country classification is perhaps the most fundamental aspect of global benchmark construction, given that country (and related currency) exposures have historically been the most important drivers of risk and return in global equity portfolios. In other words, the countries that are included in your benchmark matter a lot, so it’s critical to understand how country classification decisions are made, as well as any differences that exist between indices published by different providers.

An Overview of S&P DJI’s Country Classification Process and Evaluation Criteria
On an annual basis, S&P DJI conducts a complete review of all countries included in its global equity benchmarks. As described in detail in our country classification methodology, we initially review a series of criteria for each market that covers such areas as macroeconomic conditions, political stability, market size and liquidity, trading and settlement procedures, and the presence of foreign ownership restrictions. Countries must meet certain minimum criteria to be eligible for frontier market status, must pass higher standards for emerging market status, and must pass the most stringent criteria to be considered for developed market status.

In cases where this review indicates a possible change in classification, S&P DJI conducts an in-depth, public consultation requesting feedback from a wide range of market participants. This consultation process is an integral component of the overall country classification decision since core issues under review, such as market accessibility and the efficiency of transacting in local markets, are highly nuanced and may even vary among different types of market participants. S&P DJI typically publishes this annual consultation during the second quarter and it remains open for comment for about three months, with the results announced in the fourth quarter. In order to provide market participants with sufficient time to prepare for country changes, implementation of any changes typically happens at the following year’s September rebalancing.

In addition to the annual consultation, we sometimes conduct “off-cycle” reviews when warranted by changes in market conditions. Our consultation on Saudi Arabia is a recent example of this; the S&P DJI global equity index committee determined that market reforms implemented following our 2017 consultation period warranted a more timely review of the market.

Changes in classification are infrequent, given the index turnover and the associated trading costs borne by asset managers stemming from these large changes. Because of this, country changes are only made when there is a strong consensus among market participants for the change and the conditions supporting the change are seen as extremely unlikely to reverse.

Key Classification Differences
While classification of countries is largely consistent across the largest index providers (e.g., S&P DJI, MSCI, and FTSE Russell each have announced upgrades of Saudi Arabia this year), there are some notable differences to be aware of. Probably the most meaningful involves South Korea, which S&P DJI has classified as a developed market since 2001, but MSCI continues to classify as an emerging market. This difference is important, given that South Korea is the second-largest country in the MSCI Emerging Markets Index at a roughly 15% weight, potentially crowding out less-developed markets from the benchmark.

Another notable distinction to be aware of is that MSCI initiated a partial inclusion of China A-shares in its benchmarks as of June 1, 2018, whereas S&P DJI and FTSE Russell currently have China A-shares under review for inclusion in emerging market indices. Although MSCI’s inclusion of China A-shares has garnered significant attention, it should be noted that the partial inclusion process undertaken by MSCI means that China A-shares currently represent less than 1% of the emerging markets index.

Finally, our 2018 Country Classification Consultation is open for comment until Oct. 15, 2018. In addition to China A-shares, Argentina and Kuwait are under review for reclassification from frontier to emerging market status.

Despite both indices representing the U.S. small-cap market, the S&P SmallCap 600® has outperformed the Russell 2000 Index in 16 out of 24 calendar years, with an annualized excess return of 1.81%.[1] Prior research by S&P Dow Jones Indices[2] found that inherent differences in index construction drove the historical return differential. Notably, the profitability inclusion requirement for the S&P SmallCap 600 explains a substantial amount of the difference. Based on the conclusions found in the paper, we investigated whether similar findings exist in the international small-cap space.

In our study, we explored six widely accepted indicators of profitability by comparing the future returns of positive (or higher) profitable companies to negative (or lower) profitable companies: earnings per share (EPS),[3] asset turnover, gross profit margin, gross profitability, return on assets (ROA), and return on equity (ROE).[4]

In order to determine if differences in geographic regions or economic status lead to return differences, we tested four different regions including Global, Global Ex-U.S., Developed Ex-U.S., and Emerging Markets.

On a monthly basis, we ranked companies in each universe and grouped them into quintiles, with the most profitable (highest) companies placed into the Quintile 1 and least profitable (lowest) companies placed into Quintile 5. For EPS, we placed companies in only two groups, with Group 1 representing profitable companies and Group 2 representing negative earnings companies. We equally weighted each group to avoid size bias, with returns calculated in local currency to avoid any currency effects. Exhibit 1 shows the average of the forward one-month returns for each group within each metric, beginning in 1999.

Exhibit 1 shows that the higher-ranked groups generally delivered higher future returns relative to the lower-ranked groups across all four universes and all six metrics. In addition, the return differential between Quintile 1 and Quintile 5 (or Group 1 minus Group 2 for EPS) is shown at the bottom of each universe. Based on the results, we concluded that, irrespective of the metric used to measure profitability, more profitable companies on average outperformed less profitable ones.

To determine if the excess returns between the Quintile 1 and Quintile 5 were statistically significant, and if there was any time variation (especially over longer periods), Exhibit 2 shows the information coefficient (IC) and t-statistic for 1-, 3-, 6-, and 12-month periods for the Global Ex-U.S. universe.

The positive ICs indicated the potential predictive power of profitability metrics on subsequent excess returns. Additionally, the t-statistics showed statistical significance for the majority of the figures. The results give credence to the notion that having a profitability requirement—even something as simple as screening out unprofitable companies using EPS—could potentially have a positive effect on returns for an international small-cap benchmark.

[1]   Source: S&P Dow Jones Indices LLC, FactSet. Total returns from December 1993 to March 2018.

[2]   Brzenk, P. and Aye Soe.  “A Tale of Two Benchmarks: Five Years Later.” S&P DJI Research, March 2015.

[3]   For real estate investment trusts (REITs), funds from operations were used in place of net income when available.

[4]   Ratio Definitions: EPS is the last fiscal year net income divided by shares outstanding; asset turnover is net sales divided by the average of total assets; gross profit margin is gross income divided by net sales; gross profitability is gross income divided by total assets; ROA is gross income divided by the last two fiscal periods’ average of total assets; and ROE is the trailing 12-month EPS divided by book value per share.