Indexology^® Blog

In November, there was high market volatility in response to at least a few major events including the U.S. midterm elections, Brexit, G20 and Fed Chair Powell’s comments.  The risk (measured by 30-day annualized volatility) on Nov. 30, 2018 for the S&P 500 was 20.6%, which is 3.5 times higher than its risk of 5.9% on Oct. 9, before the Oct. 10th sell-off, and 1.4 times higher than its average risk of 15.2% (using daily data since Jan. 2, 1991, the earliest common date of the S&P 500 and S&P MidCap 400, through Nov. 30, 2018).   While the S&P MidCap 400 risk of 19.1% and S&P SmallCap 600 risk of 21.8% were also elevated ending Nov. 30, 2018, it is interesting to note the large-cap risk was higher than the mid-cap risk.  The last November when this happened occurred in 2007.

November 2007 is clearly an interesting point since it was just following the bull market ending on Oct. 9, 2007.  This does not necessarily mean the market will decline but it may be time to think about mid-caps since now the premium might be available for less risk.  Going back to 1991, when the S&P MidCap 400 was launched, it has delivered on average 3.2% extra of annualized return but at a cost of higher 1.4% annualized risk, based on daily data from Jan. 2, 1991 – Nov. 30, 2018.  It seems attractive to have earned that premium but it is not available consistently.  Note, over many commonly measured periods, mid-caps underperform large-caps.  Though, in November, mid-caps outperformed.

There seem to be moments in mid-caps that are powerful in capturing upside and limiting downside returns of the S&P 500.  Overall, the upside capture ratio is 112 while the downside capture ratio is 97.  This means, on average, for every 1% increase in the S&P 500, the S&P MidCap 400 gained 1.12%, and also, on average, for every 1% decrease in the S&P 500, the S&P MidCap 400 lost 0.97%.  Since 1991, when the S&P 500 had a positive month, it rose 3.0% while in those same months, the S&P MidCap 400 rose 3.4%.  During that same time period, when the S&P 500 fell in a month, it lost 3.4% while the S&P MidCap 400 lost 3.3%.  In fact, in 88% of months (295/335), both sizes moved in the same direction, magnifying the gains and losses. When both the S&P 500 and S&P MidCap 400 gained, the large-caps were up 3.3% versus 3.9% for mid-caps.  However, when both lost, the large-caps fell 3.9% versus 4.2% for mid-caps on average.

On an annual basis, there have been moments when strong mid-cap premiums appeared, and have been particularly helpful during difficult times such as the financial crisis, the tech bubble bust and the early 1990’s recession.  The S&P MidCap 400 outperformed the S&P 500 by 38% from 1991-1993, 81% from 2000-2005 and by 24.1% in 2007-2010.  Not only were the premiums big, but in the latter two times, the returns of the S&P 500 were negative 15.0% and 11.3%, respectively, while the S&P MidCap 400 gained 66.0% and 12.8%, respectively.  In years after the November 2007 risk discount of mid-caps to large-caps showed up, the mid-cap premium was prominent.  It was especially great when the November 1999 risk discount persisted from the preceding October. This appears similar to the current risk discount that is in its second consecutive month.

This November, the S&P 400 gained 2.9% versus the 1.8% from the S&P 500 and the 1.4% from the S&P SmallCap 600.  In mid-caps, 9 of 11 sectors were positive, while 8 of 11 large-cap sectors gained and 6 of 11 small-cap sectors gained.  Energy in the S&P MidCap 400 was the worst performer, losing 10.2% for the month on the back of a 16.7% loss, making it the worst consecutive 2-month energy sector loss since Dec. 2015 – Jan. 2016.  However, the mid-cap consumer discretionary sector rebounded, posting its biggest monthly spread over consumer staples since Sep. 2017, which could be viewed as optimistic.

Finally in November, the S&P 500 had its biggest 3-day gain of 4.23% during November 26-28 since the 3 days ending on June 30, 2016, when the index gained 4.91%.  This was largely driven by Powell’s comments and anticipation of improving trade relations from the G20 Summit.  While there have been 3-day gains larger than 4.23% only 1.8% of the time (or 436 out of 23,614 instances) in the whole history of the S&P 500 since 1928, many have happened in trending or turning environments.  In the past 5 years, 3-day gains have only happened after bottoms (or temporary bottoms.)  After the 3-day gain ending December 19, 2014, it was another 216 days until the peak and 249 days before the next bottom.  Subsequently, another rebound happened with a 3-day gain of 6.49% ending on August 28, 2015 with 67 days until the next top and 167 days until the next bottom that happened on February 11, 2016 (the index never dropped below that index level afterwards) followed by another big 3-day rebound of 5.43%, ending on February 17, 2016.

There are many factors going into December that are bullish for equities, especially mid-caps.  Equities historically perform well on average in December with every size, style and sector gaining. But mid-caps have done best.  If trading tensions ease, helping growth and pushing the dollar down, mid caps may be best positioned to perform best based on historical sensitivity.  Mid-caps gain most from a 1% dollar drop, rising on average 3.2% versus 2.6% for large-caps.  Oftentimes, the falling dollar acts as a catalyst for new international growth and propels returns beyond the mature large-caps.  Lastly, the S&P MIdCap 400 has a total return on average of 4.9% versus the S&P 500 total return on average of 4.0% per 1% of historical GDP growth.

One of the most salient themes in this year’s 29^th Annual SRI Conference was intentionality. The topic of intentionality has jumped to prominence in ESG discussions—particularly in regard to ESG ratings for mutual funds—and understanding what it means is important for ESG market participants.

In ESG terms, intentionality aims to evaluate whether a given fund or strategy has policies and procedures in place that demonstrate that the investment management process makes a concerted effort to address environmental, social, and governance issues.

Recently, fund analytics and financial information providers began to assign ESG ratings to over 34,000 funds using their proprietary scaling mechanisms and scores. Such methodologies involve a holdings-based scoring system of rolling up individual companies’ ESG ratings into a single mutual fund rating.

The reception to this type of ESG ranking for funds has been mixed, with criticism centering around the fact that the fund’s sustainability score fails to fully capture the ESG intentions of that strategy. In particular, the key concern has been that a holdings-based approach does not take into account the full arsenal of tools available to portfolio managers and investors, such as investor engagement and shareholder proposal voting.

Another criticism directed toward the rolling up method is the lack of consideration for the overarching strategies of the institution (i.e., intentionality) and the limitation in using data-based “snapshots” of funds’ holdings in isolation. For example, the situation may exist whereby a fund has invested in and is working with low ESG score companies in an effort to improve their behavior. Yet in the current scoring system, despite this particular fund’s intention to promote ESG, this fund would register as a low-ranking ESG fund. With this is mind, melding a fund’s intentionality score with the quantitative holdings data would be the preferred method in rating a fund on its ESG performance.

Therefore, the question then becomes: what would be the best way to craft an intentionality score that encompasses a qualitative and quantitative lens for the fund manager? Although there are no easy answers to that question, it has been suggested that an intentionality score should ideally focus on the past actions of the fund and review how managers have voted historically on environmental or broader ESG resolutions at major companies.

Given these concerns about a fund score based on holdings, competitors for mutual fund ESG ratings are introducing methods that are more contextualized and nuanced. For example, some providers rank funds by their initiative on ESG strategy (depth and performance), shareholder engagement, public sphere advocacy, and performance.

It is important to note that these discussions and critiques around the existing methods to evaluate intentionality highlight the transition that ESG is undertaking as it evolves from emerging to mainstream status. The mainstreaming of ESG data into fund rankings is a positive development, as discussions have moved from pinpointing the weaknesses in a company’s ESG data to those at the fund level.

After more than a year of negotiations, the United States-Canada-Mexico Agreement (USMCA) is scheduled to be signed on Nov. 30 2018, at the G20 Summit in Argentina. The deal represents the new trade agreement between the former North American Free Trade Agreement (NAFTA) countries.

Market participants who want to gain more insight into the potential impact of the new agreement on the Mexican economy and capital markets can use the geographic revenue data to estimate the percentage of Mexican equities that derive their revenues domestically, and those that derive their revenues from the U.S. and Canada.

Using the constituents of the S&P/BMV IPC CompMx as of Oct. 31, 2018, we look at the revenue exposure of the constituents based on trailing 12-month figures. We found that the majority of Mexican companies derived their revenue locally (66.72%). Roughly 9.79% of revenues came from the U.S., and the remainder came from Canada or South American countries (see Exhibit 1).

Canada accounted for less than 1% of the revenues. Including Canada, approximately 10.74% of S&P/BMV IPC CompMx companies’ revenue exposure (roughly more than a third of the 32.3% foreign revenue) came from the former NAFTA countries.

Beyond the headline revenue exposure breakdown by country, it is potentially worthwhile to dive deeper into individual industries, as trade agreements tend to affect certain industries more than others.

In Exhibit 2, we present a detailed breakdown of the Mexican industries that have exposure to the U.S. and Canada. The top three industries in descending order based on revenue exposure are Materials (43.4%), Food, Beverage & Tobacco (25.2%), and Telecommunication Services (15.5%).

It is not by coincidence that the automobile industry is a contentious topic in the new trade deal. Of the 10.74% revenue coming from the U.S. and Canada, the Automobiles & Components Industry (GICS Code 2510) is the fifth-largest in terms of weighted revenue exposure. However, based on our analysis, we find it likely that Materials and Food, Beverage & Tobacco are the two industries that would be most affected in Mexico, more so than the headline-grabbing automobile industry.

It remains to be seen who will take the biggest losses and gains in the new USMCA deal, and whether this is a step forward in international trade. At a minimum, using geographic revenue provides a rough picture of Mexican industries that have the potential to be affected.

Revenue exposure[1] gives us an additional tool to have a better understanding of what´s inside the index, characteristic, and risks that are not visible at a first glance.

[1] We used the FactSet Geographic Revenue Exposure (GeoRev^TM) dataset to calculate revenue exposure. It provides a geographic breakdown of revenues at the country level for all companies with available data.

Over the past few months, there has been a flurry of activity in the financial advisor segment of Australia. In mid-September 2018, S&P Dow Jones Indices (S&P DJI) hosted an exchange-traded fund (ETF) seminar in Perth, Western Australia. This was S&P DJI’s second foray in the West, and with Perth being one of the world’s most isolated cities, financial advisors were appreciative to have Easterners head to the West Coast.

Since the end of the mining investment boom, Western Australia has sought to realign its economy. Housing in Australia is one of the pillars of the retirement system, together with superannuation, non-superannuation assets, and the Age Pension from the federal government. With a fall in housing prices in the West, advisors have been looking for upside in other asset classes.

Advisors who attended our Perth seminar were eager to hear how they could diversify their clients’ portfolios in a cost-effective and compliant manner. One of the seminar highlights was hearing hear from local advisors as to how ETFs can revolutionize financial advisor practices. The message came through loud and clear that stock-picking or selecting managed funds to achieve particular client outcomes has become increasingly difficult and that forward-thinking advisors are reorienting from actively managed fund selection to ETF selection in order to access particular asset classes. For example, an advisor seeking Australian Equity exposure for a client would recommend investing in an ETF that tracks an S&P/ASX index rather than selecting a range of shares listed on the ASX, or selecting an Australian large-cap active fund. The SPIVA^® Australia Scorecard Mid-Year 2018 and Persistence of Australian Active Funds September 2018 Scorecard continue to show that most active funds failed to outperform their respective benchmarks the majority of the time. If advisors want to spend more time with their clients, the shift to ETFs as the core building block of a client’s portfolio could assist in this regard, while also potentially delivering the additional benefits of lower cost, greater transparency, and easy tradability.

The growth of the ETF market in Australia to just over AUD 40 billion in assets is a testament to the increasing preference of Australian financial advisors, self-managed super fund trustees, and retail investors to consider ETFs as part of a portfolio. While most assets are held in core products that track either an S&P/ASX index or the S&P 500^®, in order to secure exposure to the U.S. market, there is increasing interest in smart beta or factor-based strategies. We can expect to see ETFs that track these exposures launch in Australia. In the interim, Australian advisors can learn more by referring to How Smart Beta Strategies Work in the Australian Market.

The Financial Services Royal Commission was also a hot topic at the seminar, and also at the recent ASX Adviser Development Workshop. The concern among advisors is that the Royal Commission may recommend a slew of additional regulatory requirements, further burdening advice practices and reducing the time advisors spend with clients. Together with the new education requirements being laid down for Australian advisors, the constant rate of regulatory change in the past few years might be set to continue.

Factor investing is growing rapidly — not only are more investors adopting factor strategies, but as investors gain experience, they increase their use of them. This is one of the key findings from our recent Global Factor Investing Study, which is based on face-to-face interviews and discussions with more than 300 institutional and wholesale factor investors around the world — including financial advisors, pension funds, private banks and insurance companies.

Investors are adopting more factor strategies, but still in small doses
Factors are measurable characteristics of a security that help explain its performance. Our study found that while an asset owner often commences their factor journey with a single strategy, it is uncommon for them to stop there. The institutional and wholesale investors surveyed in the study have gone on to implement from two to four factor strategies on average.

However, factor allocations generally represent a small proportion of the asset classes they are being applied to. In the vast majority of cases (looking at equities and fixed income), allocations to factor strategies remain in the 0% to 20% range. This means that even for factor adopters, most still have over 80% of their equity and fixed income allocations in traditional active and/or market-cap-weighted passive strategies.

For those institutional investors who described themselves as “sophisticated” factor users, this segment reported nearly double the average allocation to factor strategies than the less sophisticated segment, at nearly 20%. This trend also applies to wholesale investors, where the more sophisticated users reported average factor allocations of 15%.

Which factor is the most used?
Our study found that Value continues to be the most commonly utilized style factor in portfolios and is particularly ubiquitous in institutional portfolios — which is notable given the extended underperformance of equity value strategies in recent years. Other key style factors include Low Volatility, Momentum, Size and Quality.

Respondents noted that they tend to start their factor journey with equities, and look to extend into fixed income and multi-asset applications.

Single or multi-factor?
When it comes to applying a single or multi-factor approach, our study found that equity single factors are the most common approach, closely followed by equity multi-factor. Some distance behind are multi-asset approaches, followed by single- and multi-factor fixed income.

The reasons behind these choices are relatively clear and rational.

• For institutions, single factor approaches are driven by the desire to reduce or minimize complexity and to keep costs low. This is particularly relevant for newer factor investors and smaller institutions with limited internal resources.
• Institutions favoring multi-factor approaches have different motivations — control of risk, factor tilting and enhancement of performance were cited by respondents as much more important than costs. Multi-factor strategies tend to be deployed by larger investors that have significant scale and lower cost ratios.
• For wholesale investors, the drivers are very similar, with lower costs cited as an even stronger driver for single factor usage.

Learn more about how institutions and wholesale investors are using factor strategies.