Indexology^® Blog

After the hottest January in 30 years, the broad market rally continued with 38 of 42 segments of the U.S. equity market positive in February (as of Feb. 28, 2019.)  After the Fed said it could take a break from rate hikes and it would be flexible with its balance sheet, and the market rallied, it was clear the Fed was a key driving force behind the December drop and January rally.  Now the progression of the U.S.-China trade talks seem to be helping U.S. equities further, especially driven by sectors more exposed to international revenues, like technology, materials and industrials.

The S&P 500 return of 3.0% in February added to January’s gain of 7.9% gives the index a year-to-date gain of 11.1% to start 2019.  That is the 5th biggest gain to start a year in all of the history of the S&P 500, and the best start since 1987 when the index gained 17.4% in its first two months. Other years with bigger gains in their first two months were 1975, 1943 and 1931 with respective returns of 19.0%, 12.3% and 16.9%.

Historically, when January and February each gained, there has been a significantly positive year.  Since 1938, when both January and February were positive, the year ended up on average more than 20%, and was positive 29 of 30 times – just slightly negative in 2011(-0.002%). In 26 of the 30 years, the gains were double digits, and in 15 of the 30 years, the returns were greater than 20%.  It is also worth noting that prior to 1938, January and February were each positive in 1930, 1931, 1936 and 1937 with respective annual returns of -28.5%, -47.1%, 27.9% and -38.6%.  Including these years, the average return in years gaining in each of the first two months was 15.1%.

While historically, the gains in years with positive Januaries and Februaries have been positive, it is unusual to see positive performance so broadly across segments, so there may be more divergence in performance depending on how international trade develops.  Also, S&P 500 volatility is lower now, which can result from dropping correlations between sectors.  On average through history, the annualized 30-day volatility for the S&P 500 is 15.3%, and in February dropped from 24.9% to 10.6%, which is the biggest volatility drop ever in any February, and biggest decline in a month since January 2009. It is also a volatility drop in magnitude that has only been observed seven months prior since December 1940 and including June 1948, August 1950, July 1962, December 1987, December 1997 and January 2009.  The current 30-day annualized volatility is now the lowest since mid-October, despite ongoing uncertainty both domestically and abroad.

While the S&P 500 has had a historically strong start, both the S&P SmallCap 600 and S&P MidCap 400 outperformed with respective gains in February of 4.2% and 4.1% for year-to-date returns of 15.2% and 14.9%, respectively.  Year-to-date the performance in mid-caps and small-caps has been record setting, but also, the gains have been the best ever for 20 of 42 segments.  Both value and growth in the S&P 500, as well as value in the S&P SmallCap 600 and S&P MidCap 400 have had their best starts, and both real estate and industrials logged records across sizes.

Now, a split in the sector performance has started and may continue as trade negotiations create winners and losers.  Industrials, information technology, materials, and health care may rally if trade tensions ease, and there may be more opportunity in mid-caps if the dollar falls.  These sectors have most international revenues, and health care is especially sensitive to growth.  If tensions rise, utilities, real estate and financials may perform since they have the highest percentage of revenues from the U.S., so are most insulated from trade issues.  Also, small caps are most defensive to international economic slowdowns and to a rising dollar.  Notice, already that real estate has started to fall, perhaps from the optimism over trade.

February has been a great month for factor index performance: of the 17 S&P 500®-based factor indices reported in our quarterly factor dashboard, 11 have outperformed the “vanilla” S&P 500 so far.  Our indices focused on quality and shareholder return are having particularly strong months, with the S&P 500 Dividend Aristocrats^®, the S&P 500 Buyback and the S&P 500 Quality indices all up 5% month-to-date.

As regular readers of S&P DJI’s Indexology blog and SPIVA® scorecards reports know, we cannot all outperform the market: if some stocks are outperforming, some must be underperforming.  Nonetheless, as shown above, so far in February a majority of factor indices are outpacing the benchmark.  How can so many of our factor indices be doing so well?

As we have argued previously, the clue might be in Equal Weight’s relatively strong returns.

While cap-weighted indices measure the performance of the average invested dollar, they do not measure the performance of the average stock.  As most factor indices don’t weight by capitalization, we would expect their returns to be closer to the return of the average stock than market cap weighted indices.

By definition, the return of an equal weighted index is exactly equal to the return on the average of its component stocks.  Moreover, the excess returns (or drag) realized by rebalancing back to “target” weights are frequently similar among factor strategies.  Given these similarities, when equal weight outperforms cap-weight, factor indices will also tend to outperform.

Exhibit 2 offers some empirical support.  To construct the exhibit, we began with the full set of indices shown in Exhibit 1, then pruned the group in order to avoid double counting.  For example, I picked only “Pure Value” and “Pure Growth” to represent growth and value styles, and removed multi-factor indices, resulting in 9 remaining distinct indices (excluding equal weight).  Exhibit 2 shows the average performance of those factor indices for each calendar quarter (going back to 1995), conditioned on the relative performance of S&P 500 Equal Weight that quarter.  Historically, the greater the outperformance of equal weight, the greater the proportion of outperforming factor indices.

Though the relative performance of alternatively weighted indices cannot be completely explained by equal weight performance, equal weight indices are a key part our factor toolbox for assessing when (and how) factor indices outperform.

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)