Indexology^® Blog

Even eagle-eyed commodities investors might be surprised to learn that lean hogs have been one of the best-performing individual commodities so far in 2019. As of April 5, 2019, the S&P GSCI Lean Hogs was up an impressive 19.5% since the beginning of the year, outperforming the broad S&P GSCI (up 18.4%), and up 46% since Feb. 20, 2019. While lean hogs might seem like a trivial asset to cover in this medium, even in the relatively idiosyncratic world of commodities, it illustrates an important characteristic of individual commodity markets, namely their usefulness in expressing investment theses that are dependent on unique geopolitical, demographic, structural, weather, and health or disease factors. It also provides a timely reminder of the impact that significant price adjustments in real assets, such as commodities, have on underlying levels of economic activity, inflation, and fiscal and monetary policies.

The driving force behind the rally in lean hog prices has been a disease outbreak and its expected impact on supply. Lean hogs spent the first two months of the year in the doldrums, fixated on higher-than-expected levels of U.S. pork production and ongoing market access restrictions for U.S. pork in key export markets. By March, these factors were dwarfed by the realization that the scope, severity, and impact of the African swine flu (ASF) outbreak in China had been greatly misunderstood. ASF doesn’t affect humans but has a very high mortality rate in pigs and has no vaccine or cure. According to the FAO, China announced its first ASF outbreak on Aug. 3, 2018, and has since confirmed 118 outbreaks.[i]

To put the Chinese market in perspective, China is both the largest producer and consumer of pork in the world and has a hog herd conservatively estimated to be in excess of 430 million, almost three times the size of the next largest herd (in the European Union). Colleagues at S&P Global Platts have recounted that news reports from China suggest that only 20 of the 100 breeding herds in China are disease-free: the supply impact of ASF could be sizeable and long-lasting (sows have a gestation period of “three months, three weeks and three days” and pigs do not reach slaughter weight until they are at least six months old). The USDA’s attaché in Beijing has forecast Chinese pork production at 51.4 million metric ton this year, down 5% from 2018, with imports forecast to hit 2 million metric tons, up 33% year over year.[ii]

The spread of ASF risks creating a big hole in global pork supply, and the U.S. is likely best suited to fill this hole, as U.S. supplies are expected to increase, while supplies in other markets are steady or even declining. However, it is worth noting that at this time, U.S. pork producers continue to contend with a retaliatory 50% tariff in China (on top of the regular tariffs faced by all other importing countries). The tariff in China continues to make products from other countries more competitive versus the U.S., at least in the short term. Filling the disease-induced supply hole will not be straightforward.

The broader implications of ASF and higher pork prices, particularly in China, are noteworthy. Pork is believed to be the single largest item in the Chinese CPI basket (official components and weights are not disclosed), and while domestic Chinese pork prices are notoriously volatile, policy makers are undoubtedly already worried about more than just the rising cost of their red-fried pork lunch.

There have been no reported outbreaks of ASF in commercial hog herds in the U.S. or Western Europe, but the potential impact of an outbreak on lean hog prices in either region could prove to be momentous.

[i]   http://www.fao.org/ag/againfo/programmes/en/empres/ASF/situation_update.html

[ii]   https://www.fas.usda.gov/data/china-livestock-and-products-semi-annual-4

Risk-adjusted returns showcase the return accrued for every unit of risk held in a portfolio. If two portfolios have the same returns over a given time period, the one that has the lowest risk will have the better risk-adjusted return. Modern portfolio theory (MPT) assumes that an investment with higher risk should compensate the investor, on average, with higher returns.[1]

In addition to observing the performance of funds purely on a return basis (as seen in the SPIVA^® India Year-End 2018 Scorecard), it may also be useful to determine whether funds, adjusting for risk, are able to beat their respective category benchmarks. This analysis seeks to establish whether actively managed funds are able to generate higher risk-adjusted returns than their corresponding benchmarks over long-term investment horizons.

The standard deviation of monthly returns was used as a measure of risk (volatility) for this analysis. We used the return/risk ratio to evaluate managers’ risk-adjusted performance. To make our comparison relevant, we also adjusted the returns of the benchmarks by their volatility.

The analysis resonates the same message that we saw in the SPIVA India Year-End 2018 scorecard (see Exhibits 1a and 1b)—on a risk-adjusted basis, a large proportion of actively managed equity funds underperformed their benchmarks over long-term horizons.

Exhibit 1b shows that adjusting for risk does not necessarily portray a stronger case for active fund managers. For example, in large-cap and Equity-Linked Savings Scheme (ELSS) categories, we can still see that more than 45% of the active fund managers underperformed their respective category benchmarks on a risk-adjusted return basis across different time horizons. However, in the case of the mid-/small-cap segment, active funds fared relatively better; a little more than 50% of funds outperformed the S&P BSE 400 MidSmallCap Index across the 3-, 5-, and 10-year horizons.

Source: S&P Dow Jones Indices LLC, Morningstar, and Association of Mutual Funds in India. Data as of Dec. 31, 2018. Past performance is no guarantee of future results. Table is provided for illustrative purposes.

Source: S&P Dow Jones Indices LLC, Morningstar, and Association of Mutual Funds in India. Data as of Dec. 31, 2018. Past performance is no guarantee of future results. Table is provided for illustrative purposes.

At an aggregate level, the asset-weighted basket of mid-/small-cap active funds witnessed better risk-adjusted returns than the S&P BSE 400 MidSmallCap Index with a notably lower return volatility (see Exhibit 2). On the contrary, large-cap and ELSS active funds noted worse or similar risk-adjusted returns to the S&P BSE 100 and S&P BSE 200 benchmarks, respectively, across different investment horizons. Therefore, one may notice that it is becoming increasingly difficult for fund managers to beat their respective benchmarks both on an absolute return basis and risk-adjusted returns basis.

Source: S&P Dow Jones Indices LLC, Morningstar, and Association of Mutual Funds in India. Data as of Dec. 31, 2018. Past performance is no guarantee of future results. Table is provided for illustrative purposes.

Experience the active vs. passive debate on INDEXOLOGY^®.

[1]   https://spindices.com/documents/research/research-risk-adjusted-spiva-scorecard.pdf

The first quarter of 2019 was one of synchronized gains across stocks, bonds, and commodities. Stocks soared, with the S&P 500^® up 13.6%, recording its largest first quarter gain since 1998. Amid a dovish tone from the Fed, U.S. Treasury yields declined, with the yield on the 10-year U.S. Treasury Bond falling to its lowest level since 2017. Commodities rebounded strongly, with the S&P GSCI finishing the quarter up 15.0%.

While their positive correlation is unlikely to continue long term, these three asset classes helped the S&P Risk Parity Indices to record attractive first quarter returns. In fact, the indices—which aim to spread risk equally across equities, fixed income, and commodities—have been propelled to new all-time highs.

Exhibit 3 shows the performance of the S&P 500, the hypothetical global 60/40 portfolio, and the S&P Risk Parity Indices from Q4 2018 and Q1 2019, as well as the cumulative return across both quarters. While the S&P 500 posted strong performance in Q1 2019, the impact of declines in Q4 2018 meant it ended about 1.7% off its closing level in September 2018. Furthermore, the “equity-concentrated” global 60/40 portfolio only managed to break even across the two quarters, despite strong performance from fixed income.

In contrast, the S&P Risk Parity Indices shrugged off their Q4 2018 weakness, as Q1 2019 helped to more than make up for those losses. This is largely due to their allocation methodology that aims to equalize the risk contribution of each asset class and hence is not “equity-concentrated.”

By examining the performance attribution and asset class weights across the S&P Risk Parity Index – 10% Volatility Target in Exhibits 4 and 5, it is clear where this outperformance comes from. It is the fixed income component, with back-to-back quarter gains and a higher proportion of weight, which has primarily driven the index to new highs. The 4.8% gain posted by fixed income since the end of September 2018 has more than offset the losses in the other two asset classes.

While inappropriate to judge the S&P Risk Parity Index – 10% Volatility Target based on two quarters worth of performance, this can be seen as an endorsement of its allocation methodology over the 60/40 portfolio. By equalizing the risk contribution of each asset class, the S&P Risk Parity Indices tend to exhibit a smoother return profile that is less exposed to equity market drawdowns. It is this mechanism that has brought active and passive risk parity products to investors’ attention.

In this blog, the third in our introduction to Growth at a Reasonable Price (GARP) strategies, we look at risk and return.

The main objective of the S&P 500^® GARP Index is to capture the performance of growth stocks with relatively high quality and value composite scores over a long-term investment horizon. Historically, the GARP strategy has delivered higher returns than the underlying benchmark.

Rebasing all indices to 100 on June 30, 1995, the S&P 500 GARP Index reached 1,631.76 on Jan. 31, 2019, while the S&P 500 reached 777.91. In Exhibit 1, we compare the performance of the S&P 500 GARP Index with other factor indices—the S&P 500 Growth (855.24), the S&P 500 Enhanced Value Index (1155.30), and the S&P 500 Quality Index (1564.67).

Exhibit 2 shows the average risk/return profile of the S&P 500 GARP Index against single-factor indices. The S&P 500 GARP Index had the highest annualized average return, at 13.48%. On a risk-adjusted basis, the S&P 500 GARP Index ranked second (0.76) after the S&P 500 Quality Index (0.93), but was higher than the other factor indices—the S&P 500 Enhanced Value Index (0.66) and S&P 500 Growth (0.67)—as well as the S&P 500 (0.67).

With the S&P 500 as the underlying benchmark, we can use the information ratio (IR) to evaluate whether a strategy was able to add value for each incremental unit of active risk taken (see Exhibit 3). The IR is defined as the expected active return divided by the tracking error (TE), where active return is the difference between the return of a strategy and the return of the S&P 500, and the TE is the standard deviation of the active return.

In Exhibit 3, the S&P 500 GARP Index had a positive IR of 0.50 over a long-term investment horizon. The index had a higher IR than the S&P 500 Growth (0.12) and S&P 500 Enhanced Value Index (0.25), but had a lower IR than the S&P 500 Quality Index (0.57).

In our next blog, we will continue to cover targeted factor exposures, sector composition, and performance attributions of the GARP strategy.

Fluctuating periods of “risk-on” and “risk-off” mean that spikes in equity market volatility and large drawdowns are increasingly common in today’s economy. Exhibit 1 shows events throughout the current market cycle causing notable rises in volatility and large drawdowns. With more of these likely in the future, as our long bull market cycle ages, how do investors best position portfolios to respond?

Many investors are familiar with the passive indices that exist to gain broad market exposure in a low-cost, liquid, and transparent manner. But one question worth asking is which passive strategies have the potential to outperform during periods of negative equity performance and increased volatility? The good news is there are several.

S&P DJI offers a variety of indices specifically designed to help smooth out equity market drawdowns and improve risk-adjusted return. These indices can be divided into three broad categories: defensive equity, multi-asset, and volatility.

Exhibit 3 highlights and provides links to some of the indices that fall into these categories and shows their performance during Q4 2018—the most recent high volatility event. Many of the indices listed in Exhibit 3 posted material outperformance in Q4 2018.

Passive strategies can take on a much more dynamic role than simply offering broad market exposure. Investors can consider these strategies a valuable tool as they seek to weather periods of increased market volatility and large drawdowns.

For an overview of the indices shown in Exhibit 3, as well as an examination of their performance during other notable periods of increased volatility, please check out our new paper, “Seeking Volatility Protection Using Indices”.