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Bonding with Defensive Equity Strategies

Low Style Consistency in Large-Cap and Mid-/Small-Cap Fund Categories

Active Management Lags in Small-Cap Equity

SPIVA® U.S. Mid-Year 2018 Summary

Cost of Retirement Income Q3 2018 Update

Bonding with Defensive Equity Strategies

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Fei Mei Chan

Former Director, Core Product Management

S&P Dow Jones Indices

“The aim of the wise is not to secure pleasure, but to avoid pain.”

– Aristotle

Recent volatility in equity markets may be unsettling to some investors. Skittishness about the stock market is understandable, especially in the context of the serenity in 2017. Volatility levels are relatively higher and risk is on the radar of investors’ consciousness again.

Historically, bonds have been the preferred asset class in times of turmoil. The bull market for bonds in the last 30+ plus years meant the tradeoff in returns wasn’t that much of a sacrifice. But, as the chart below shows, at current interest rate levels, bonds as a means of defense are less attractive than they’ve typically been.

In this context, we looked at defensive equity strategies as a means of lowering overall portfolio risk. The S&P 500 Low Volatility Index is the classic example of a risk-reducing strategy; the index tracks the 100 least volatile stocks in the S&P 500.   As the chart below reflects, this index has consistently delivered less volatility than the S&P 500 from 1991 to 2017 on a 10-year rolling basis.  Despite its lower risk profile, the S&P 500 Low Volatility Index has, anomalously, outperformed the S&P 500 in the 27+ years from 1991 to year-to-date 2018.

More recently, during this year’s two major market declines on February 5, 2018 (S&P 500: -4.1%) and October 10, 2018 (S&P 500: -3.3%), the low volatility index also lived up to its objective, outperforming the S&P 500 on both days.  

Low Volatility is perhaps the quintessential defensive equity strategy, but it’s by no means the only one.  Our new paper, Defense Beyond Bonds, provides a deeper discussion of risk-mitigating approaches to equity management.





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

Low Style Consistency in Large-Cap and Mid-/Small-Cap Fund Categories

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Akash Jain

Director, Global Research & Design

S&P BSE Indices

Style plays an important role in an investor’s asset allocation decisions. In the SPIVA India Mid-Year 2018 Scorecard, one can notice the low style consistency, especially in the Indian Equity Large-Cap and Indian Equity Mid-/Small-Cap categories. The Securities and Exchange Board of India (SEBI) circular dated Oct. 6, 2017, mandated the following important directives for the Mutual Fund Industry.[1]

  1. It defined five equity size categories ranked by total market capitalization:
    1. Large Cap (80% of assets invested in equity; ranked from 1-100)
    2. Mid Cap (65% of assets invested in equity; ranked from 101-250)
    3. Small Cap (65% of assets invested in equity; ranked from 251-500)
    4. Multi Cap (65% of assets invested in equity)
    5. Large and Mid Cap (at least 35% of assets invested in large caps and at least 35% assets in mid caps)
  2. It obligated mutual funds to manage only one product offering in each category. Therefore, a fund house with multiple offerings in the same category would have to either merge, liquidate, or change the style of its existing schemes to the same category if necessary.

These mandates have had important implications for the mutual fund industry and investors. The fund houses had to not only align their portfolios as per the size definitions laid out, but they also had to ensure a unique offering in each size category. For example, as per the second rule, a mutual fund house offering two large-cap schemes would have to either liquidate one scheme, merge it into another scheme, or change the style of one of the offerings.

The aforementioned implications may have been one of the reasons for the relatively lower style consistency over the one-year period ending in June 2018, as funds would have initiated the process to align their product offerings with SEBI’s guidelines.

Exhibit 1: Style Consistency in the Indian Equity Large-Cap and Mid-/Small-Cap Categories
Total Funds Available in June 2017 66 45
Style-Consistent Funds 28 33
Style-Inconsistent Funds 38 12
Category Style Consistency (%) 42.4 73.3

Source: S&P Dow Jones Indices LLC, Morningstar, and Association of Mutual Funds in India. Data from June 30, 2017, to June 30, 2018. Past performance is no guarantee of future results. Table is provided for illustrative purposes.

For example, in the case of the 66 large-cap funds available at the end of June 2017,[2] three failed to survive the one-year investment horizon. During this period, a total of nine funds moved to the newly defined focused fund category, eight moved to the large- and mid-cap fund category, and nine moved to the multi-cap fund category (see Exhibit 2). This resulted in an overall style consistency of 42.4% for Indian Equity Large-Cap funds over the one-year period ending in June 2018 (see Exhibit 1).

For the Indian Equity Mid-/Small-Cap fund category, the style consistency was higher than for large caps, at 73.3%. Few funds moved to the new large- and mid-cap, multi-cap, and focused fund categories.

Exhibit 2: Breakdown of Style Inconsistency in Funds
Total Style Inconsistent Funds 38 12
Dead Funds 3
India Fund Aggressive Allocation 1
India Fund Children 1
India Fund Contra 1
India Fund Dynamic Asset Allocation 3
India Fund Equity – Other 3 1
India Fund Focused Fund 9 2
India Fund Large & Mid-Cap 8 3
India Fund Large-Cap NA
India Fund Mid-Cap NA
India Fund Multi-Cap 9 2
India Fund Small-Cap NA
India Fund Value 1 3

Source: S&P Dow Jones Indices LLC, Morningstar, and Association of Mutual Funds in India. Data as of June 30, 2018. Past performance is no guarantee of future results. Table is provided for illustrative purposes.

A change in style during the investment tenure may potentially affect the risk/return characteristics of a portfolio. For example, a multi-cap fund offering participation to small-cap stocks has the potential to augment returns but at a higher risk and potential drawdown in comparison with a large-cap fund, which may not have been an investor’s initial expectation at the time of investment.

[1]   Data from SEBI.

[2]   Data as per Morningstar category classifications.

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

Active Management Lags in Small-Cap Equity

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Hamish Preston

Head of U.S. Equities

S&P Dow Jones Indices

Small caps have a reputation among many market participants as being an inefficient asset class that lends itself to active management.  But our S&P Indices Versus Active (SPIVA®) scorecards have repeatedly challenged this perception.  Exhibit 1 shows that in 13 of the last 17 calendar year periods, the majority of actively managed, small-cap U.S. equity funds failed to beat the S&P SmallCap 600®.

Exhibit 1:  Most Small-Cap U.S. Equity Funds Have Underperformed Each Year

More recently, our latest U.S. SPIVA results show a whopping 72.88% of small-cap U.S. equity funds underperformed the benchmark in the 12-month period ending June 30, 2018.  While these results may appear perplexing, particularly as small-cap was one of the best-performing asset classes in the same period (the S&P SmallCap 600 rose 20.50%), the choice of benchmark can help to explain the record of relative performance.

The S&P SmallCap 600’s profitability screen made it a more difficult benchmark to beat.

Historically, there has been a significant difference in returns between profitable and non-profitable companies.  For example, cap-weighted portfolios comprising U.S. small-caps with at least four trailing quarters of positive EPS (Group 1) outperformed those without a history of positive EPS (Group 2) between 1994 and 2014.

Exhibit 2: A Positive Earnings Screen Boosted Performance

Source: “A Tale of Two Benchmarks: Five Years Later”, Brzenk and Soe, March 2015

A simple yet effective strategy would have therefore been to screen for profitability, which the S&P SmallCap 600 does.  Compared to less-discerning small-cap benchmarks, this profitability screen has typically offered an annual performance pick-up of around 2%, making the S&P SmallCap 600 more difficult to beat.  For example, while nearly 73% of small-cap U.S. equity managers underperformed the S&P SmallCap 600 in the 12-month period ending June 30, 2018, 63.84% failed to beat the Russell 2000 index.

As a result, understanding the choice of benchmarks used in our semi-annual SPIVA scorecards can help to explain relative performance figures.  Indeed, an understanding of the S&P SmallCap 600’s profitability screen can add color as to when and why active U.S. small-cap equity managers have, or have not, been able to outperform.





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

SPIVA® U.S. Mid-Year 2018 Summary

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Berlinda Liu

Former Director, Multi-Asset Indices

S&P Dow Jones Indices

The latest results from the SPIVA U.S. Mid-Year 2018 Scorecard show improvement in the relative performance of actively managed domestic equity funds against their respective benchmarks. During the one-year period ending June 30, 2018, the overall percentage of all domestic funds outperforming the S&P Composite 1500® increased to 42.02%, compared with six months prior (36.57%). During the same period, 63.46% of large-cap managers, 54.18% of mid-cap managers, and 72.88% of small-cap managers underperformed the S&P 500®, the S&P MidCap 400®, and the S&P SmallCap 600®, respectively (see Exhibit 1).

Exhibit 2 shows that, among the three market cap segments, small cap (20.50%) was the best performing segment over the 12-month period ending June 30, 2018. Nevertheless, compared to active managers in the large-cap and mid-cap segments, more small-cap managers underperformed their benchmark, the S&P SmallCap 600. This finding dispels the myth that small cap is an inefficient asset class in which active management offers the best solution to access. Year after year, the SPIVA U.S. Scorecard has repeatedly shown that the majority of small-cap active managers have underperformed the S&P SmallCap 600, and this trend can be seen in all the periods studied.

While the near-term performance of active equity funds improved, the majority still underperformed their benchmarks over the medium term as well as the longer-term investment horizon (see Exhibit 3). For example, over the five-year period, 76.49% of large-cap managers, 81.74% of mid-cap managers, and 92.90% of small-cap managers lagged their respective benchmarks. Similarly, over the 15-year investment horizon, 92.43% of large-cap managers, 95.13% of mid-cap managers, and 97.70% of small-cap managers failed to outperform on a relative basis.

Similarly, across all investment horizons measured, managers in each of the international equity categories underperformed their benchmarks. Furthermore, the longer the time horizon, in general, the more funds underperformed. Over 94% of active emerging market equity funds and nearly 79% of international developed equity funds underperformed when measured over the 15-year horizon.

Similar to our findings in the U.S. small-cap space, emerging market equities is also another asset class where conventional wisdom dictates using active management to access. However, as the SPIVA U.S. Scorecard results have repeatedly shown, an overwhelming percentage of active emerging market equity managers have difficulty beating their benchmark.

It is also worth noting that compared to the results from six months prior, more international equity managers underperformed their benchmarks in the one-year investment horizon, especially in the international small-cap category.

When it comes to fixed income, during the 12-month period ending June 30, 2018, the majority of actively managed funds investing in long-term government and long-term investment-grade bonds underperformed their benchmarks, but their relative performance over the benchmarks improved compared to six months prior. In contrast, funds investing in short- and intermediate-term investment-grade bonds outperformed their benchmarks.

Experience the active vs. passive debate on a global scale on Indexology®.

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

Cost of Retirement Income Q3 2018 Update

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Philip Murphy

Former Managing Director, Global Head of Index Governance

S&P Dow Jones Indices

Real U.S. interest rates have shifted upward YTD in 2018, with a larger shift on the short end than the long̬̬—producing a flatter curve. Exhibit 1 shows the real yield curve (from 5 to 30 years) at the end of each quarter since December 2017 and also includes data as of Oct. 9, 2018 to reflect a recent move since September 2018.[1]

The curve shift produced lower present values of inflation-adjusted cash flow streams for future retirees. These changes are quantifiable and shown in Exhibit 2. Each bar represents a cost decrease of 25-year, inflation-adjusted cash flows, commencing at the respective 5-year increments indicated on the horizontal axis for the year-to-date through Sept. 28, 2018 period.[2]

What is the significance for retirement savers? When rates decline (increase), static wealth levels buy less (more) income. For example, the cost of income commencing in 2030 declined by $1.51 (to $19.58 as of September 2018 from $21.09 in December 2017). For a given wealth level, a 2030 retiree can expect to generate almost 8% additional income. Here’s the arithmetic for a $100,000 hypothetical account.

As of December 2017: $100,000/$21.09 = $4,742.24 of inflation-adjusted income per year starting in 2030

As of September 2018: $100,000/$19.58 = $5,108.34 of inflation-adjusted income per year starting in 2030

($5,108.34/ $4,742.24) – 1 = 7.7%

A key lesson is that uncertainty comes in more flavors than market risk. The cost of future income, driven by interest rates, can be a major source of uncertainty. Even if a portfolio has not changed in value YTD in 2018, the amount of future income one could buy currently would have increased by almost 8% due to the shift in interest rates. On the other hand, had rates moved downward, the opposite would be true, which is tricky because most investors tend to feel safer if their investments do not change in value. The takeaway is that when investors are trying to provide future income for themselves, low portfolio volatility does not typically equate to low income volatility due to movements in interest rates.

How can one manage such variability? One way would be to gradually allocate more assets to a portfolio structured to hedge interest rates. The trade-off is that when you hedge interest rates, or the future variability of the amount of income you’ll have, you give up the opportunity to participate in the long-term growth of stock markets. This trade-off is one of the central long-term risks that retirement investors should consider carefully and develop an investment policy to manage.

[1] U.S. Department of the Treasury.

[2] For more information, see S&P STRIDE Metrics.

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