Indexology^® Blog

LIBOR – the London Interbank Offered Rate — is the benchmark for over $300 trillion of loans, derivatives and other financial instruments.  LIBOR started in the syndicated loan market of the 1960s; today it is quoted in different currencies and maturities. Following scandals in 2012-2013, LIBOR is being replaced and will disappear in 2021.

For US dollar denominated loans and derivatives, the replacement for overnight LIBOR will be SOFR (Secured Overnight Financing Rate). It is based on overnight REPOs used by the Fed as part of its interest rate management. The New York Federal Reserve bank began publishing SOFR this time last year. Other overnight rates are being established covering the UK, Europe, Switzerland and Japan. (See the table.)  Initially these will be quoted as overnight rates only; regulators and industry groups are beginning to discuss term rates for maturities longer than overnight.

Originally, London-based banks set LIBOR by sharing estimates of what each bank could expect to pay for to borrow overnight money without collateral. Today’s process is more formal, however LIBOR continues to be partially based on estimates of what overnight funding would cost a recognized bank. SOFR has two key differences: it is calculated from actual trades, not estimates. It is a secured rate based on REPOs of US treasury securities.  Over time, SOFR may drop below LIBOR since it is a secured rate. Further, in a crisis a secured rate like SOFR rate could fall while an uncollateralized rate like LIBOR rises.

In 1986, when LIBOR was well established and widely used, the British Bankers Association, with the support of the Bank of England, formalized the LIBOR rate setting and changed the process to exclude the highest and lowest quotes in each setting. Beginning in 2007 there were rumors and articles in the press raising questions about the LIBOR process and suggestions that a bank might quote low rates to enhance its credit quality. In 2012, several banks were found to be manipulating the rate to their own advantage. A year later in 2013 the European Union levied financial penalties totaling over $2 billion against a group of eight major banks. SOFR and other LIBOR replacements use of actual trades from liquid markets to prevent a repeat of the scandals that plagued, and then, brought down LIBOR.

The chart shows the Fed funds rate, US dollar overnight LIBOR and SOFR over the last year. SOFR tends to move sharply at quarter-ends when banks look to the repo market for window dressing. As more funds focus on SOFR, it may become less volatile.

The methodology of the S&P BSE SENSEX has seen many changes over the last 30 years. In October 2018, it was again modified after an extensive market consultation.

The recent changes brought new clarity to the boundaries for entry and exit of stocks in the index. Constituents are selected by size and liquidity. Now, any constituent with a free-float market cap rank beyond 39 will be dropped from the index and any non-constituent with a rank equal to or less than 21 will qualify for inclusion in the index. This helps the S&P BSE SENSEX methodology become rules-based, transparent, and objective.[1]

Using the new methodology as a part of the semiannual index reconstitution, Asia Index Private Ltd (a joint venture between S&P Dow Jones Indices and BSE Ltd) announced changes to the S&P BSE SENSEX composition on November 22, 2018. Bajaj Finance (a leading non-banking finance company company) and HCL Technologies (a leading global information technology company) replaced Wipro and Adani Ports and Special Economic Zone (see Exhibit 1). These changes were effective as of the market open on December 24, 2018.

The S&P BSE SENSEX noted total returns of 7% over the three months since the previous rebalance. During this period, new members Bajaj Finance and HCL Technologies outperformed the index by 2.5% and 0.6%, respectively, on a total returns basis. Good though this outperformance is, it had a minor effect of 0.27%, combined, on the index’s total return, on account of the two new companies’ small weight in the index.

Source: Bloomberg and Asia Index Private Limited. Contribution and total returns from Dec. 21, 2018, to March 22, 2019. Weight as of rebalance as of Dec 21, 2018. Past performance is no guarantee of future results. Table is provided for illustrative purposes.

Historically, India’s equity market has been dominated by the Financials sector, and this is also true of the S&P BSE SENSEX. The weight of Financials in the index before the October 2018 changes was 41.5%. It increased by 1.3% to 42.8% on account of the inclusion of Bajaj Finance. The Industrials sector noted a fall of 0.9% in sector weight with the exclusion of Adani Ports and Special Economic Zone.

Source: Asia Index Private Limited. Weights as of Dec. 21, 2018. Table is provided for illustrative purposes.

The S&P BSE SENSEX, India’s most tracked bellwether index, is designed to measure the performance of the 30 largest, most liquid, and financially sound large-cap companies across key economic sectors of the Indian economy. The index represents approximately 44% of BSE-listed companies in terms of total market capitalization. It follows a free-float-adjusted, market-cap-weighted methodology and is reviewed semiannually in June and December.

[1] For detailed methodology please visit www.asiaindex.co.in.

The SPIVA^® U.S. Year-End 2018 Scorecard shows a reversal of the relative short-term performance of fixed income funds at the end of 2018 from six months prior. Combined with the interest rates move, this might shed some light on understanding the duration positioning of active funds.

We focus on government bond funds for our analysis, since duration positioning is the most important directional exposure for this type of strategy. Exhibits 1 and 2 show changes in interest rates alongside the relative performance of government bond funds as compared to their benchmarks, using one-year gross returns.

When the bond markets changed direction from a sell-off in the first half of 2018 to a rally in the second half, the percentage of short and intermediate bond funds underperforming their benchmarks increased significantly, from 22% and 11%, to 52% and 65%, respectively. At the same time, the reverse happened to long-end government bond funds. These quick inversions of performance may indicate that most short and intermediate bond funds were underweighting duration going into the second half, and the ensuing bond rally caught active bond managers by surprise.

Yet the SPIVA Year-End 2018 showed consistent underperformance from more than half of the funds in most of the taxable bond fund categories over the mid- and long-term periods. For example, as of the end of 2018, more than 50% of such funds underperformed their benchmarks on five-year net return.  This divergence between short- and long-term relative performance by taxable bond managers is not unique in the history of SPIVA.

Exhibit 3 shows the percentage of fixed income funds underperforming benchmarks historically on one-year and five-year bases, where the red text indicates years when more than 50% of the funds lagged benchmarks. More than 50% of the funds outperformed their benchmarks occasionally over the one-year basis, but it was less common over the five-year horizon.

The latest SPIVA U.S. report shows that more than 50% of short and intermediate bond funds underperformed their benchmarks after outperforming six months ago. Our analysis shows that on a five-year return basis, such a switch of relative performance was unusual, as underperformance was persistent.

Information Technology and Financial Sectors Biggest Contributors

Global S&P and Dow Jones Shariah-compliant benchmarks outperformed their conventional counterparts in Q1 2019 as Information Technology—which tends to be overweight in Islamic indices—finished the quarter at the top of the sector leaderboard while Financials—which is underrepresented in Islamic indices—underperformed the broader market. The S&P Global BMI Shariah and Dow Jones Islamic Market (DJIM) World each gained 14.3% and 14.1%, respectively, outperforming the conventional S&P Global BMI by approximately 200 bps.

The outperformance trend played out across all major regions as Shariah-compliant benchmarks measuring U.S., Europe, Asia Pacific, and emerging markets each finished the quarter ahead of conventional equity benchmarks by meaningful margins.

U.S. Equities Led the Rest of World in Q1

The S&P 500^® Shariah marked its best quarterly return since the inception of the index in 2006, with a gain of 15.0%. A more dovish stance from the U.S. Federal Reserve and hopes for a U.S.-China trade breakthrough helped push U.S. equities higher in the quarter following a more tumultuous close of Q4 2018. Europe and Asia Pacific equities followed in performance, as each enjoyed double-digit percentage gains.

MENA Equities Underperformed – Country Results Varied

After MENA equity outperformance in 2018, the S&P Pan Arab Composite lagged high-performing emerging and global markets during Q1 2019 with a gain of 9.4%. The S&P Egypt BMI led the way in the region in Q1, gaining a solid 19.3%, followed by the S&P Bahrain BMI, which added 15.0%. The Saudi Arabia BMI, which was promoted to emerging market status in March, gained a favorable 14.1%. The S&P Oman BMI and S&P Qatar BMI lagged the most, falling 1.6% and 1.1%, respectively.

For more information on how Shariah-compliant benchmarks performed in Q1 2019, read our latest Shariah Scorecard.

A version of this article was first published in Islamic Finance News Volume 16 Issue 14 dated April 10, 2019.

In this blog, the fourth in our introduction to Growth at a Reasonable Price (GARP) strategies, we cover factor exposures, sector composition, and performance attribution.

Targeted Factor Exposures

Exhibit 1 shows the active exposures (in percentages) of the S&P 500^® GARP Index to the five factors used in GARP strategies: three-year sales per share (SPS) growth (SGROW), three-year earnings per share (EPS) growth (EGROW), earnings-to-price ratio (EP), return on equity (ROE), and financial leverage ratio (LEV). Active exposure is defined as the portfolio factor exposure minus the benchmark factor exposure. Factor percentage exposure is defined as the active exposure of one factor divided by the sum of all five factors. The monthly average of all periods is taken to represent the average active exposure. In Exhibit 1, we see that SPS growth and EPS growth had exposure levels that dominated the factor exposures, with 31% and 27%, respectively. EP, ROE, and LEV had exposures of 14%, 11%, and 16%, respectively. The factor exposure levels in the first layer of filters doubled that of the second layer of filters. The exposure results show that the multi-factor sequential filtering approach achieved its design goal.

Sector Composition and Performance Attribution

GARP strategies use bottom-up stock selection. The only constraint on sector composition is that each sector is capped at a maximum of 40%. As shown in Exhibit 2, the active weight of the S&P 500 GARP Index didn’t exceed 7%. The active weight is defined as the portfolio sector weight minus the benchmark sector weight. The two-factor Brinson attribution analysis shows that strategy outperformance mainly comes from stock selection rather than sector allocation. These findings are in line with our bottom-up strategy design process.

In conclusion, the multi-factor sequential filtering approach has achieved its designed goal for GARP strategies. Moreover, sector composition and performance attribution analysis show that the strategy has limited active sector exposure, and its outperformance is mainly due to stock selection.