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The IMF Comment May Push South Africans to Sovereigns

Shelter from the Storm

Sizing Up U.S. Equities In Managing Brexit Risk

Why Credit Should Not Be an Independent Asset Class Within a Risk Parity Benchmark

Valuing Research: Three Questions

The IMF Comment May Push South Africans to Sovereigns

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Kevin Horan

Former Director, Fixed Income Indices

S&P Dow Jones Indices

The South African economy, Africa’s second-largest economy after Nigeria, may be helped by reforms put in place by President Cyril Ramaphosa. Earlier this year, South Africa suffered a setback, as data showed the economy dipping into a recession, but Ramophosa has since unveiled a stimulus and recovery plan to try and get it back on track. The stimulus package encouraged investors by giving more certainty on mining and visa rules and by emphasizing skill development and education.

As the debate continues, the IMF has publicly stated, “Some of the initial optimism has dissipated as growth remains stuck in low gear and reform implementation has faced constraints.”[1]

Concerns over the economy tend to push local investors to the most secure investments and entice international investors to attractive yields. The performance of the South African sovereign market can be quickly reviewed with the S&P South Africa Sovereign Bond 1+ Year Index, which seeks to track the performance of local currency-denominated sovereign debt publicly issued by the government of South Africa in its domestic market, with maturities of one year or more.

Year-to-date, the index returned 5.55% as of Nov. 16, 2018. As mentioned above, the index history shows that, as the South African economy suffered a setback, risk-off trading led to an increased demand for sovereign bonds, and the yield to worst of the index reached a low of 8.29% on March 27, 2018. Since March, yields have increased and are currently ranging between 9.4% and 9.8% (see Exhibit 1).

Looking at the structure of the index, the universe of bonds currently includes 14 securities, with a market value of ZAR 1.4 trillion. The duration of the index is 7.2 years, with 9 of the 14 securities having a duration greater than the aggregate level.

The 2-year sovereign South African bond (7.25% on Jan. 15, 2020) began the year with a weight of 4.4% in the index but currently only holds 2%, as longer issues have increased in weight. As seen in Exhibit 2, the yield of the 2-year sovereign bond has tightened, while the 5-, 10-, and 30-year sovereign bonds have moved laterally. Since the beginning of September 2018, the 2-year sovereign bond bid yield has gone from a YTD high of 7.88% to 6.35%.

 

Some investors are skittish, as Africa’s most industrialized economy struggles with rising debt, though the government is working hard to improve the investment climate for both domestic and international investors, according to the minister of trade and industry.

For more information on the S&P South Africa Sovereign Bond Index and the S&P South Africa Inflation-Linked Bond Index, please go to www.spdji.com or follow these links.

S&P South Africa Sovereign Bond Index

S&P South Africa Sovereign Bond 1+ Year Index

S&P South Africa Sovereign Inflation-Linked Bond Index

S&P South Africa Sovereign Inflation-Linked Bond 1+ Year Index

[1] Toyana, Mfuneko. “IMF says optimism in South Africa’s economic recovery fading.” Reuters. Nov. 19, 2018.

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

Shelter from the Storm

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Anu Ganti

U.S. Head of Index Investment Strategy

S&P Dow Jones Indices

As we approach the final month of a rollercoaster year in the markets, adding a factor lens can provide perspective, especially when it comes to low volatility.

The goal of low volatility strategies is to provide investors with protection in falling markets and participation in rising markets. The need for protection has become more relevant as a result of recent market declines in the U.S. and prolonged weakness overseas.

Through September, low volatility in the U.S. was the ugly duckling of factor strategies, underperforming the S&P 500® and lagging far behind the then-ascendant growth and momentum strategies. However, the tide turned in October, which was a rough month (to say the least) for U.S. equities. As seen in Exhibit 1, the S&P 500 lost 7%, while the S&P 500 Low Volatility Index outperformed by 4%, providing a much needed protective cushion. Exhibit 2 shows that the most important component of low volatility’s success was the strong relative performance of Utilities, where low volatility has a substantial overweight.

Low volatility’s success was not unique to the U.S. Exhibits 3 and 4 show that similar trends occurred globally, particularly in the emerging markets and Asia, regions that have experienced turmoil for most of this year. The S&P Pan Asia Low Volatility Index and S&P BMI Emerging Markets Low Volatility Index outperformed their benchmarks by 12% and 11%, respectively, for the one-year period ending October 2018.

Low volatility strategies have been successful across regions and time horizons in providing protection during market declines.

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

Sizing Up U.S. Equities In Managing Brexit Risk

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Jodie Gunzberg

Former Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

One of the main recent headlines has been the strength of the UK pound from the proposed Brexit transition.  This brings into question how investors in the UK and Europe may possibly position themselves in the U.S. equity market. Notice in the past five days, the USD to GBP started from a high of 1.305 on Wed, just to drop slightly to 1.302 on Thursday before plunging to 1.275.

Also, while not as much as in the U.S., volatility has crept up in the UK with the S&P United Kingdom BMI (US Dollar) 30-day annualized volatility reaching 16.1% on Nov. 15, nearly doubling its level of 8.7% on Sep. 27.  With the increase in volatility, especially in large caps in the S&P 500, investors may question the power of the U.S. equities to diversify a UK or European equity allocation.

Source: S&P Dow Jones Indices.

However, the longer term returns from the U.S. are significantly higher over several periods, which makes the case for excluding them difficult to prove.  While most international investors use the large caps for their U.S. equity exposure, perhaps one may consider the historical benefits of mid-cap or small-cap that have been more powerful, especially now that the volatility of large caps has risen to the level seen in the S&P MidCap 400 and S&P SmallCap 600.  If the long-term historical outperformance of the small-cap and mid-cap hold, then one may earn almost a 3% annualized premium over the long term – as long as there is quality like in the S&P 500, S&P MidCap 400 and S&P SmallCap 600.

Source: S&P Dow Jones Indices.

The mid-caps and small-caps also have lower historical correlation with international equities.  For example the correlation of the UK to U.S. large-caps is 0.81, but is just 0.67 to small-caps.  This is likely not just from size but from the percentage of revenues generated domestically that differ from larger to smaller companies.  The S&P SmallCap 600 generated nearly 80% of revenues from the U.S., while the S&P 500 generates just over 70%.

Source: S&P Dow Jones Indices. Monthly data from Sep. 1998 to Sep. 2018 of the top ten countries in the S&P Global Broad Market Index (BMI) (US Dollar) and the S&P 500, S&P SmallCap 600 and S&P MidCap 400.

Not only is there more potential diversification in the traditional sense from lower correlation of smaller companies to international equities, but there is more downside protection historically from mid-caps and small-caps than from large-caps. For every 1% drop historically in the UK, the S&P 500 fell on average 58 basis points, while the S&P MidCap 400 fell on average 51 basis points and the S&P SmallCap 600 fell on average just 44 basis points.

Source: S&P Dow Jones Indices. Monthly data from Sep. 1998 to Sep. 2018 of the top ten countries in the S&P Global Broad Market Index (BMI) (US Dollar) and the S&P 500, S&P SmallCap 600 and S&P MidCap 400.

Lastly, one may consider that whether the dollar falls or rises, large caps are not historically positioned to benefit most.  If the dollar falls on average 1%, mid-caps have performed best gaining on average 3.2% versus 2.6% for large caps and 3.0% for small-caps. Meanwhile if the dollar rises 1% on average, it is small-caps that have performed best, gaining on average 95 basis points, while mid-caps gained 82 basis points on average and large-caps gained least on average with just 71 basis points.  This is since the small caps have most revenue generated domestically but mid-caps have the capacity to grow business internationally when the dollar falls.

Taking into account the dollar volatility, the lower correlation, higher returns, lower downside capture ratios and now even volatility, an international investor may like to consider moving beyond large caps for their U.S. equity allocation and include mid-caps and/or small-caps.

 

 

 

 

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

Why Credit Should Not Be an Independent Asset Class Within a Risk Parity Benchmark

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Michael Rulle, Jr.

Founder, CEO

MSR Investments, LLC

This blog post was co-authored with Matthew Brown, President and COO, MSR Investments, LLC.

We believe there are two critical criteria an index must meet to be considered a benchmark:  1) it must be easy to implement as a viable investment alternative to managers that pursue the same strategy, and 2) it must define only the underlying beta that is common to the portfolios of all managers of the strategy. #1 is the reason we believe futures contracts work as constituents to the S&P Family of Risk Parity Indexes.  #2 is the reason we approve credit as an excluded asset class in this family of benchmarks.

The fact that some practitioners of risk parity have chosen to exclude credit from their portfolios would be reason enough to exclude credit from a benchmark.  However, we would like to take this opportunity to provide a more thorough explanation.  When we analyze the returns of credit indices and their impact on relative performance inside a risk parity portfolio, it becomes clear that when an investor gains exposure to credit they may in fact be gaining exposure to 3 underlying betas:  1) equities, 2) fixed income, and 3) short volatility.  Therefore, if we add credit exposure to a theoretical risk parity portfolio (or index) then we may simply be increasing exposure to equity and fixed income beta, which also ultimately has the effect of reducing exposure to commodities – the “parity” portion of the strategy is disrupted.  Furthermore, to add credit to the benchmark may also accidentally add a new, undesirable beta to the strategy – short volatility.

Since the end of 2008 to the end of September 2018, the daily serial correlation of the S&P 500 High Yield Corporate Bond Index is 0.46 along with 63.8% of positive return days.  These are both extraordinarily high numbers and are often endemic to option selling strategies.  [There is no explicit option selling in the index, so high yield investors are implicitly selling volatility.]  This concept manifests itself in a conditional correlation relationship with equities where the correlation (between equities and high yield credit) rises towards 1 with spikes in market volatility.  You need to look no further than the market behavior of February and October of this year to see an example of this phenomena.

We also compared the relative performance of risk parity managers (using a popular 10% Target Volatility (“TV”) manager-based risk parity index as a proxy for manager returns) to the S&P TV10 Risk Parity Benchmark over time to a theoretical 50/50 (Equities/Fixed Income) TV10 portfolio of futures contracts.  We correlated the relative performance of rolling 12 month returns of managers (i.e. managers’ return minus the benchmark return) to the 50/50 TV10 portfolio and got a correlation of 0.73 over the last eight years (prior to eight years ago there were very few managers in this space).  This comparison demonstrates that by adding credit to their portfolios, managers may simply be adding equity and fixed income beta, which the S&P Benchmarks already capture.  The two reasons that correlation isn’t even higher are likely 1) some managers (including the inventor of the strategy) do not invest in credit, and 2) the aforementioned exposure to volatility.

None of this analysis precludes the inclusion of credit in a risk parity portfolio.  The reason to hire a manager is because you want that manager to provide alpha relative to the benchmark.  We simply see credit as an alpha pursuing vehicle that combines underlying betas rather than providing exposure to its own unique beta.  And we don’t believe any this information should be controversial because an investor has the choice to invest with a manager or invest in investment products linked to the benchmark.  The manager vs benchmark analysis is now the same in risk parity as it is in other asset classes thanks to the S&P Family of Risk Parity Indexes.

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

Valuing Research: Three Questions

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Hamish Preston

Head of U.S. Equities

S&P Dow Jones Indices

We recently introduced a new measure, capacity-adjusted dispersion, to help conceptualize the relative value of research across different markets.  Intuitively, capacity-adjusted dispersion combines the potential opportunity for outperformance (dispersion) and the potential size of active positions (capitalization) in a given market.  Exhibit 1 shows the capacity-adjusted figures for several markets, globally.  All else being equal, for example, insights into S&P 500 sectors would have been over seven times more valuable than equally-accurate insights into S&P 500 stocks.

Exhibit 1: Capacity-Adjusted DispersionSource: The Value of Research: Skill, Capacity, and Opportunity.  Past performance is no guarantee of future results.  Chart is provided for illustrative purposes.

At first glance, Exhibit 1 makes grim reading for research analysts covering small- or mid-cap U.S. equities: the relatively small market capitalizations of stocks in the S&P MidCap 400 and the S&P SmallCap 600 more than neutralizes their higher dispersion, resulting in low capacity-adjusted dispersion figures.  However, the results do not necessarily mean there is no value to receiving research covering small- or mid-cap U.S. stocks.

One important assumption of the stylized framework outlined in our paper is that the predictive content of research is the same for all analysts.  In reality, this is unlikely to be true: some analysts are likely to be better than others at predicting how constituents (stocks, sectors, or countries) will perform in the future.  If we allow the predictive content of research reports to vary, Exhibit 1 has another interpretation: the predictive content of research covering S&P SmallCap 600 stocks needed to be 50 times more accurate than for research covering S&P 500 stocks in order for the two research values to be the same.  Exhibit 2 shows the relative predictive content required to make the value of research for each of the indices in Exhibit 1 equal to the value of research for S&P 500 stocks.

Exhibit 2: Predictive Content Required for Equivalent Research Value Source: The Value of Research: Skill, Capacity, and Opportunity.  Past performance is no guarantee of future results.  Chart is provided for illustrative purposes

Deciding how to allocate a research budget is a challenging task.  Nonetheless, our stylized framework suggests three questions are important:

  • How accurate are research reports’ predictions?
  • What is the potential reward to being correct?
  • How big can an investor’s active positions be?

Answering these three questions may help market participants use their research budgets more effectively when attempting to deliver alpha.

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