Indexology^® Blog

A few years back on highlighting the benefits of passive investing or index investing; there was skepticism on its ability to get a foothold in Indian financial markets. How the tides have turned! Now, not only do we have the skeptics accepting its value, but also propagating the concept. Undoubtedly, India is still largely an active market within the scope of generating alpha on average market returns. However, market trends and statistics are now creating awareness of this alternative investment strategy.

To better understand passive or index-based investing, one must first understand what an index is. An index is a basket of securities designed to represent a concept, asset class, geography, or strategy. Indices are designed with clear rules that are defined in a transparent methodology that forms the guidelines for the stocks that enter or exit the index during periodic reviews. These periodic reviews are known as rebalancing and are critical for the index to remain relevant during changing market conditions. For example, if the index methodology has a rule that states only companies with consistent quarterly profits can be part of the index, and one of the companies does not meet the rule during the index’s quarterly rebalancing or review, the company will then be dropped from the index and the next company in line that qualifies will enter the index.

A transparent methodology ensures there is no bias in the selection of stocks and that the index follows the design it was created for. Independent index providers add further neutrality to the index creation process.

Additional benefits of the passive style are:

• Access to a diversified basket, thereby avoiding concentration risk;
• Rather than a single stock, single sector, or single asset class focus to a broader choice of a basket of stocks via an index; and
• Lower costs, as index-based investing does away with the additional costs of active research trading, management charges, etc.

In India, some of the headline indices are the S&P BSE SENSEX, S&P BSE 100, and S&P BSE 500. Statistics have revealed that in certain segments, such as large caps, active strategies have been underperforming benchmark indices. This means that the indices are providing higher returns compared with certain large-cap active funds.[i]

As of Dec. 31, 2018, the amount of assets in exchange-traded funds in India was valued at approximately INR 11,236 crores, a 44% year-over-year growth, which was lower than the 115% and 126% growth rates seen in 2016 and 2017, respectively.[ii]

Source: Bloomberg. Data as of Dec. 31, 2018. Past performance is no guarantee of future results. Table is provided for illustrative purposes.

While the debate of active versus passive is ongoing, the belief that both styles can be encompassed to achieve various investment objectives is changing the horizon in Indian financial markets. Passive investing is not only here to stay but to grow.

Explore the active versus passive debate on Indexology^®

[i]   https://www.indexologyblog.com/2018/06/26/indexing-route-to-large-caps/SPIVA^® India Mid-Year 2018

[ii]   Source: Bloomberg

When it comes to style investing, pure style indices that select and weight securities based on their style scores tend to be less correlated with each other, have higher return spreads, and higher betas to the benchmark than the traditional market-cap-weighted style indices that have overlapping securities.

Additionally, when one style is favored over the other, the pure style version typically does better than the traditional style.  The asymmetric performance and higher market sensitivity highlights the potential for pure style indices to undergo extended periods of underperformance than their style counterparts. Because of this, market participants often partake in style rotation (holding growth or value) or hold a combination of both styles to harvest style premium.

The decision to hold a combination of style indices or rotate entirely out of one style may come from a number of signals, ranging from valuation-based to macroeconomic conditions. In this blog, we do not attempt to discover signals for allocations; rather we take a simplified approach of computing hypothetical portfolios that combine pure value and pure growth at different weights.

To demonstrate this, we create 11 hypothetical portfolios by changing weights in 10% increments (going from 100% value, 0% growth to 0% value, 100% growth) based on the S&P 500 Style Indices. Exhibit 1 shows the annualized return and risk in a scatter plot (left chart) and the return/risk ratios (right chart) of the style portfolios from 1998 to 2018. Exhibit 2 shows the same analysis using the S&P Pure Style Indices.

Comparing the two sets of charts, for any given combination of growth and value, portfolios allocating to the pure style indices had higher return/risk ratios. For example, a portfolio with a 50%/50% mix of traditional value and growth had a reward/risk ratio of 0.40, while the same weight mix using pure style indices had a return/risk ratio of 0.50. Therefore, we are able to conclude that on a risk efficiency basis, the higher volatility in the pure style combinations is compensated by the additional return compared to style. The results point to the potential effectiveness of combining pure value and pure growth in the U.S. large-cap space.

Learn more about the S&P Style and S&P Pure Style Indices on Indexology^®.

The start of 2019 marks not only the 10^th anniversary of S&P Dow Jones Indices in Dubai, but also the expansion of our single- and multi-factor index series into the Gulf Cooperation Council (GCC) region. Our current suite of single factor indices, including those covering low volatility, momentum, enhanced value, and quality factors, are now available based on the S&P GCC Composite,[i] S&P Saudi Arabia,[ii] and the S&P Saudi Arabia Domestic Shariah.[iii] A multi-factor index that combines quality, value, and momentum is also available for the same three markets. The introduction of these indices into the GCC region is apropos, as these key markets now have the necessary liquidity and market capacity to support these new strategies. Moreover, the presence of factor indices in the region will provide investors with greater exposure to risk factors and enable them to use the indices to target specific investment objectives.

The construction of the factor indices in the GCC region is similar to that of our current factor indices, subject to additional selection, capping, and liquidity criteria. For example, target stock count for the S&P Saudi Arabia Factor Indices and S&P Saudi Arabia Shariah Factor Indices is determined by a maximum of 30 stocks, 20% of the number of constituents in the universe, or the number of stocks (ranked by factor score), such that the sum of their free-float market capitalization is at least 50% of the free-float market capitalization of the eligible universe. The indices are subject to capping based on security weight, country weight, and GICS^® sector weights. Additionally, stocks must have a minimum six-month median daily value traded of USD 1 million (or USD 500,000 for current constituents) as of the rebalancing reference date. These additional criteria ensure that there is sufficient liquidity to support the strategies.

Our current suite of factor indices spans across various markets including, but not limited to, the global, developed, and emerging markets. When compared to the factor indices in these regions using the information ratio, we observed that the performance of the S&P GCC Factor Indices was historically similar to what has been observed in other regions. In fact, over the 10-year period studied, we saw that the S&P GCC Factor Indices achieved higher excess returns per unit of tracking error for most factors relative to the other regions.

Overall, the factor indices in these markets outperformed their benchmark. In Exhibit 2, we highlight a specific strategy—the S&P GCC Composite Quality, Value & Momentum Multi-Factor Index. We see that this strategy consistently outperformed the benchmark, demonstrating that it was effective in providing stable excess returns and improved risk-adjusted returns. An interesting point to note when looking at the performance across all of the factors for the GCC region is the decrease in performance around 2015-2016. This is a result of the price of oil dropping during those years to historical lows due to oversupply and disagreements between Organization of the Petroleum Exporting Countries (OPEC) and non-OPEC nations. As a result, we see that the five-year performance of the indices was lower, as the index values were recovering to reach their peak values from 2014.

Exhibit 3 shows that the factor indices, with the exception of low volatility, outperformed their benchmark over the 10-year period. The indices mostly had higher returns and higher volatility, thus, they all outperformed their respective benchmarks on a risk-adjusted basis. We also observed that the quality, value & momentum indices outperformed the single factors in each region. This shows us the potential benefits of combining single factors, including diversification and improved performance.

Stay tuned as we continue to build out new strategies to fulfill market demand in the GCC region.

[i]   For more details on the S&P GCC Composite Factor Indices, please see: S&P GCC Composite Low Volatility Index, S&P Enhanced Value GCC Composite Index, S&P Momentum GCC Composite Index, S&P Quality GCC Composite Index, S&P GCC Composite Quality, Value & Momentum Multi-factor Index

[ii]   For more details on the S&P Saudi Arabia Factor Indices, please see: S&P Saudi Arabia Low Volatility Index (USD)/(SAR), S&P Enhanced Value Saudi Arabia Index (USD)/(SAR), S&P Momentum Saudi Arabia Index (USD)/(SAR), S&P Quality Saudi Arabia Index (USD)/(SAR), S&P Saudi Arabia Quality, Value & Momentum Multi-factor Index (USD)/(SAR)

[iii]  For more details on the S&P Saudi Arabia Shariah Factor Indices, please see: S&P Saudi Arabia Shariah Low Volatility Index (USD)/(SAR), S&P Enhanced Value Saudi Arabia Shariah Index (USD)/(SAR), S&P Momentum Saudi Arabia Shariah Index (USD)/(SAR), S&P Quality Saudi Arabia Shariah Index (USD)/(SAR), S&P Saudi Arabia Shariah Quality, Value & Momentum Multi-factor Index (USD)/(SAR)

The S&P 500 Low Volatility Index^® made a valiant comeback in late 2018 after trailing for most of the year.  The strategy index finished the year well by just staying in positive territory at a 0.27% gain, when the broader S&P 500 declined 4%.  It was also the best performing factor index among those based on the S&P 500.  To date in 2019, it is predictably trailing the broader benchmark, up 9.2% versus a gain of 10.1% for the S&P 500.

Since the last rebalance for the S&P 500 Low Volatility Index, volatility continued to increase universally across all sectors of the S&P 500.  Among the sectors that increased the most in volatility was Information Technology, up five percentage points, while Utilities’ volatility increased the least.

It is therefore not surprising that the low volatility index increased its weight in Utilities in the latest allocation shuffle; the sector now composes a quarter of the index.  The other significant shift was Health Care, which gave back what it gained in allocation in the previous rebalance.  Unexpectedly, Information Technology’s weight in the low volatility index remained more or less unchanged. This likely means that volatility levels of stocks within the sector were widely dispersed, with pockets of relative stability.

A headline from yesterday was very intriguing: “Why investors crave a return to the art of stock-picking.”  Copious data demonstrate the peril of placing hope in active management.  The article argues that since we seem to be in a trend that favors value, it is a good time for managers to pick stocks based on fundamental value metrics.

The point that value has recently been beating growth has some merit.  The chart below shows the performance cycles for S&P 500 Growth versus S&P 500 Value since 1995.  There has been a shift in course since October 2018, with the growth index declining 8% versus just 4% for the value index.

Value, like many other factors, cycles in and out of favor. When it is in vogue, value managers might have an easier time beating the broad market—a value manager might well look good against the S&P 500 when value is beating growth.  But that doesn’t necessarily mean that he is adding value as an active value manager.

It is important, in other words, not to conflate the performance advantage of value over growth with the process of stock selection within a value universe.  To do otherwise is to confuse style with selection.

The “indicization” of many investment strategies has allowed for cheap access to previously-unavailable factor strategies. The availability of factor indices “…makes the active manager’s life harder.  In former days, he could expect to be paid both for providing access to factor exposures as well as for stock selection; today, he’s increasingly limited to stock selection as factor exposure is indicized.”

Value might be back in favor, but that does not imply that beating a value index by stock selection is likely. S&P Dow Jones Indices’ SPIVA report also covers style fund managers— whose results are consistent with those of broad market fund managers.  Most style managers underperform their respective benchmarks most of the time.