Indexology^® Blog

The S&P 500 closed April 23, 2019, at a new record high. The index’s closing value of 2,933.68 is the highest since the 2,930.75 posted on Sept. 20, 2018. From that previous high, the benchmark declined 19.86% to 2,351.10 by Dec. 24, 2018, narrowly avoiding bear market territory. December 2018 was the second-worst December in the history of the S&P 500, only better than December 1931.

In the first seven trading days of 2019, the S&P 500 marked its 12^th best start on record since 1928 and its best since 2003. The index rebounded, posting three consecutive positive months to start 2019, pausing only briefly around 2,800 resistance levels. April is currently on pace to post the fourth consecutive month of gains. As of the close on April 23, 2019, the S&P 500 was just 2.26% away from reaching 3,000.

Market corrections are often short lived and the recovery swift—this most recent occurrence was no exception. Since the start of 1989, there have been 10 instances when the S&P 500 declined over 10% from a record high, which averages to about once every three years, and the average number of trading days it took for the S&P 500 to reach a new record high again was 428. Excluding the dot-com crash (March 2000-October 2002; 1,803 days to new high) and housing crisis (October 2007-March 2009; 1,376 days to new high), the average of the remaining eight instances was 138 trading days, or roughly six months. This most recent period, September 2018 to April 2019, had 146 trading days between new record highs.

Earnings season is underway and has helped push the S&P 500 to its new record close. Although far from complete, and with many noteworthy companies yet to report, earnings reported thus far have been solid overall, buoyed by modest expectations. Among other factors, the correction from the previous high in September was triggered by fears of slowing economic growth in China and Europe, the escalating U.S.-China trade dispute, expectations that the Federal Reserve would continue raising interest rates, and a softening housing market. These issues remain mostly unresolved, but sentiment has shifted with progress being made in U.S.-China trade negotiations and the Fed becoming more dovish to the point that it paused rate increases and unwinding its balance sheet for the foreseeable future.

The Dow Jones Industrial Average^® is rebounding, but has not yet fully recovered from the correction. Closing at 26,656.39 on April 23, 2019, The Dow^® sits just 0.65% below its all-time high close of 26,828.39 (Oct. 3, 2018). The mid- and small-cap core indices are also approaching—but have not yet surpassed—their pre-correction highs, and they could be considered to have lagged large caps in the rebound. The S&P MidCap 400^® and S&P SmallCap 600^® would need to rise by another 4.03% and 13.04%, respectively, in order to achieve new highs.

Indices based on factors such as low volatility and quality generally have defensive characteristics. These strategies tend to outperform the broad benchmark in down markets, as previous studies have shown.  Yet some market participants also believe that active management fares somewhat better than the benchmark in periods of volatility and distress. In 2018, the S&P 500^® rallied 10.56% in the first three quarters and lost 13.52% in the fourth; this provides a good test to compare actively managed mutual funds against passive defensive factor strategies and see which rode the rollercoaster better. In our test, we also include the S&P 500 Equal Weight Index.

Different factors deliver different investment results, due to unique defensive mechanisms. In 2018, low volatility and dividends outperformed while quality lagged, compared with the median performance of all large-cap mutual funds. In the long term, when cyclicality of the market has been smoothed out, all these passive strategies tended to outperform the majority of actively managed mutual funds (see Exhibit 1).

In 2018, 64% of large-cap active funds underperformed the broad market, but even more managers underperformed the S&P 500 Low Volatility Index (88%) and the S&P 500 Dividend Aristocrats^® (73%). Though quality has been considered a defensive factor, it did not perform as well as low volatility or dividends in 2018. Meanwhile, nearly 57% of active large-cap managers beat the S&P 500 Quality Index.

In the five-year period ending December 2018, the S&P 500 Low Volatility Index and S&P 500 Dividend Aristocrats outperformed over 85% of the large-cap active managers. In addition, over 66% of active large-cap funds had lower returns than the S&P 500 Equal Weight Index and the S&P 500 Quality Index.

Over the longer-term 15-year period, all four factor indices outperformed more than 98% of the large-cap mutual funds. This is not surprising, given that these defensive factor indices historically tend to have higher hit rates and excess returns in down markets (see Exhibit 2).

Financial market performance in 2018 clearly can be split into two periods. Despite the flash crash in February and heightened market volatility in April, the first three quarters saw a strong rally thanks to solid corporate earnings. However, in the fourth quarter, uncertainty over global economic growth and future Fed policy wiped out the year’s gains for many equity benchmarks. This happened in all the defensive factor strategies as well as the two reference indices (see Exhibit 3).

Exhibit 3 clearly shows the source of 2018 outperformance for the low volatility and dividend factors: lower beta and less cyclical companies, which lagged the broad market rally in the first three quarters but created far less drawdown in the fourth quarter market shakeup. Both the S&P 500 Low Volatility Index and the S&P 500 Dividend Aristocrats have a higher percentage of these firms than the S&P 500.

The S&P 500 Quality Index did not fare as well in 2018 due to its sector composition. This index selects securities based on their quality score, which is a composite of three fundamental ratios: balance sheet accruals ratio, return on equity (ROE), and financial leverage ratio. The use of a profitability metric or ROE significantly increased the index’s weight in Information Technology, which posted an 18% loss in the last quarter of 2018, while reducing the index’s allocation to Health Care, Biotechnology in particular, which posted a return of 15% during the first three quarters of 2018.

Professionals in varied fields are often too busy to research, plan, and understand the best investment style.  A common worry is the risk associated with equity markets.  Yet this anxiety is primarily due to myth and inadequate knowledge.

To protect, add value, and grow their assets, both institutional and retail investors face a myriad of options.  Investment institutions have access to unlimited research and high-quality advice, but individual investors do not have it so easy.

If these investors knew about “passive investing”, they would have less reason to worry.  Passive investing is also known as index-based investing.  An index is a basket of financial instruments — equity (stocks), debt (bonds), or commodities — designed by established, professional, independent index providers, such as S&P Dow Jones Indices (S&P DJI), that do not trade or create investment products, but publish the index level and constituents.

Well-designed indices underlying passive investment allow a person with insufficient financial knowledge to participate confidently and easily in the market and its trends.  And just as important, an index gives exposure to a diversified basket of investment instruments at low cost.

The structure of an index can be based on an asset class, geography, strategy, a theme, or some other concept.  An index provides the advantages of diversification, avoiding the concentration risk of single stock or instrument exposure.  It offers transparency and non-bias through its publicly available rules-based methodology: For example, it invests in the index basket exactly in the same proportion provided by the index.  Further guiding investment strategies, the equity content of the index may from time to time be adjusted according to market trends and cycles.

Trends of several indices over the last few years are shown in Exhibit 1.  Investments in products based on such indices would be likely to follow similar trends. Index performance will also be varied based on the index design and methodology as shown in Exhibit 2.

Exhibit 1: Performance of Different Indices

Source: S&P Dow Jones Indices LLC. Data as of Apr. 19, 2019. Data has been based at 100. Past performance is no guarantee of future results. Chart is provided for illustrative purposes.

Source: S&P Dow Jones Indices LLC. Data as of Mar. 29, 2019. Past performance is no guarantee of future results. Table is provided for illustrative purposes.

Passive investment index funds and exchange-traded funds follow different indices for varied strategic purposes.  Indices can track markets, such as the S&P BSE SENSEX for Indian markets or the S&P 500 for US markets.  Other indices track sectors, such as the S&P BSE Bankex, the S&P BSE Energy, and the S&P BSE Finance.  As well, Factor Indices are now making headway into global markets and India, with quality, momentum, value, and low volatility as single factor or multi-factor variants.  S&P DJI offers many different indices suited to varied conditions, characteristics, and risk-return features.

Passive investment by individual Indian investors was negligible a few years back, but now constitutes over USD 12 billion.  Globally markets have realised the potential of this strategy, with over USD 5 trillion assets invested passively.

The distinctive growth of assets through “passive” products is compelling impetus to consider passive investing as the first preference in an investment strategy.

Dividends and stock buybacks are two ways that a company returns capital to its shareholders. Investors can benefit from both, but is there a synergy that can result from combining them?

We’ve seen a surge in both buyback value and the number of participating companies in recent years. In 2018, 444 of S&P 500^® companies spent USD 806 billion on buybacks.[1] Additionally, more dividend-growing companies have begun repurchasing shares while consistently increasing dividend distribution. Exhibit 1 shows this trend in the S&P 500 Dividend Aristocrats^®.

To evaluate the two forms of shareholder payouts, we compared dividend yield[2] and buybackyield[3] (see Exhibit 2). Buyback yield was significantly lower than dividend yield before 2003 and became quite unstable until the end of the financial crisis. From then on, buyback yield surpassed dividend yield.

Choosing between dividends and share repurchases is a contentious debate. Income-oriented investors may prefer dividends, while growth-oriented investors may desire the capital appreciation that buybacks bring. Although either payout strategy can benefit investors over time, an alternative and holistic strategy would be to integrate the two.

Using the S&P 500 Buyback Index[4] and the S&P 500 Dividend Aristocrats,[5] we formed a hypothetical portfolio of companies with sustainable dividend yield and high buyback yield. The hypothetical index of indices approach is a simple guideline because there is a possibility of overlap between the two strategies. However, we find that overlap between the two indices is fairly low—6.4% on average when measuring on a quarterly basis from December 1998 to December 2018. The combined strategy does indeed display the highest risk-adjusted return over the long-term investment horizon (see Exhibit 3), indicating that investors could benefit from integrating both factors.

[1] “S&P 500 Q4 2018 Buybacks Set 4th Consecutive Quarterly Record at $223 Billion,” S&P Dow Jones Indices.

[2] Dividend yield is the annual dividend amount relative to the market value.

[3] Buyback yield is the stock buyback value relative to the market value.

[4]   The S&P 500 Buyback Index is designed to measure the performance of the top 100 stocks with the highest buyback ratios in the S&P 500. For more information, please visit https://spindices.com/indices/strategy/sp-500-buyback-index.

[5]   The S&P 500 Dividend Aristocrats is designed to measure the performance of S&P 500 companies that have increased dividends every year for the last 25 consecutive years. As of March 29, 2019, the index contains 57 issues. For more information, please visit https://spindices.com/indices/strategy/sp-500-dividend-aristocrats.

In general, it is a positive sign when a company buy back shares. This means the company believes its stock is undervalued and is confident about its future earnings. In recent years, buybacks have become increasingly popular. With a record number of companies buying back shares, how are these companies are faring?

A company can choose to return value to shareholders in a number of ways: it can pay out cash dividends, reinvest in the business, buyback shares, or a combination of these.[1] Traditionally, paying out dividends has been the dominant method to return a company’s excess cash to investors, and dividend income returns have contributed to over one-third of the monthly total return of the S&P 500 from 1928 to 2016.[2] In a share repurchase, a company reduces its shares outstanding through an open-market buyback or tender offer.

Exhibit 1 charts the aggregate amount of dividends and repurchases of S&P 500 companies since 1998. While cash dividends show a steady increase over time, the amount of shares repurchased has been volatile. The amount of buybacks jumped significantly right before the 2008 global financial crisis and dropped drastically in 2009. Since 2010, the amount of buybacks has continuously grown and exceeded the amount of dividend distributions.

The buyback momentum has continued into 2019, even after a record USD 806 billion[3] buyback in 2018, a 56% increase from the previous year. As shown in Exhibit 2, two decades ago, fewer than half of S&P 500 companies purchased shares back. The participation rate stood at around 80% as of Dec. 31, 2018.

Since its inception in January 1994, the S&P 500 Buyback Index returned 13.29% annually, compared with gains of 10.31% and 8.96% from the S&P 500 High Dividend Index and S&P 500, respectively. One of the key reasons for the outperformance is that buying shares back decreases the company’s shares outstanding, which helps improve earnings-per-share (EPS) and eventually propels stock prices higher.

[1]   Zeng, “Examining Share Repurchasing and the S&P Buyback Indices in the U.S. Market” (April 2016)

[2]   Li and Soe, “Incorporating Free Cash Flow Yield in Dividend Analysis” (November 2017)

[3]   “S&P 500 Q4 2018 Buybacks Set 4th Consecutive Quarterly Record at $223 Billion,” S&P Dow Jones Indices