Indexology^® Blog

Economics used to be Political Economy. Today politics in encouraging economics to look at different ideas such as Modern Monetary Theory. MMT argues that a country which borrows in its own currency will never default: as long as the US sells bonds denominated in US dollars, it won’t matter how big the federal budget deficit becomes.

MMT isn’t a free pass to unlimited government spending. However, it makes a case that a new government program doesn’t need to be matched by tax increases or spending cuts. Medicare and defense spending are not about to bankrupt the government. Under MMT, tax policy as well as monetary policy would be used to control inflation.

1. If a government borrows in its own currency it can always avoid default by printing more money,
2. Inflation can be controlled through higher taxes to limit spending,
3. Monetary policy can focus on interest rates rather than inflation and growth,
4. Fiscal policy is freer to support economic growth and jobs.

The U.S. normally borrows in its own currency – the Treasury sells bills, notes and bonds denominated in U.S. dollars. The Federal Reserve buys treasuries by crediting a bank’s account at the Fed – it prints money — to pay for treasuries. As long as the Treasury keeps issuing debt, the Fed can keep creating bank reserves and buying bonds. Therefore, the government cannot default as long if its debts are in dollars. If investors lose faith in US treasuries and decide to buy corporate or foreign bonds, the Fed could still keep printing money and funding the government. As extreme as this may sound, it is not that different from Quantitative Easing (QE). Under QE, the Fed bought bonds by crediting banks’ accounts at the Fed in an effort to increase spending across the economy and raise economic activity.

Of course, excessive borrowing and unlimited printed money is not a good approach to government finance. There aren’t any free lunches in economics. Were the government to spend without limit it would boost the demand goods and services, push prices up, squeeze resources and accelerate inflation. Under a traditional approach to inflation control via monetary policy, the Fed would raise interest rates, to curtail economic activity and cut inflation. Under an MMT monetary regime, the Fed would be committed to funding the treasury. Inflation would be controlled through higher taxes. If large increases in the government or the private sector spending caused inflation, the higher taxes would lower private sector spending while cutting the amount of government debt the Fed needed to buy.

Today the federal budget deficit is 4%, and total federal spending is 21%, of GDP. The 4% is funded by selling debt; the rest (17%) is paid for by federal tax revenues. Switching to MMT would disrupt the economy and create a flood of debt and cash. If taxes were trimmed, private sector spending would balloon and drive inflation sky high.

While few analysts looking at MMT would suggest abandoning the current monetary policy structure, many believe that government-spending decisions should not be dominated by fears of larger deficits. Spending proposals should be evaluated on their benefits and costs, not by what program must be cut to pay them. Behind every government program there is a Congressman, Senator or cabinet secretary who will fight to keep – or raise – its budget. As long as each new dollar must be paid for by giving up an old dollar, there will be very few new dollars even if the return would be substantial.

Although MMT is a new angle in deficit debates, the federal deficit is as old as the country. As the chart shows, deficits have been the rule in this century and more often than not over the last 90 years.  The message to take from MMT is that a bit more federal spending will not bankrupt the country whether or not monetary policy is turned on its head.

The S&P 500^® was up 3.93% in April, marking the fourth consecutive month of gains. The YTD gain of 17.51% was the best since 1987 and the fifth-best in the entire history of the index. The index set a new all-time high in April, surpassing the previous high close from Sept. 20, 2018. This completed a full recovery from the 19.86% decline in the fourth quarter of 2018. Over the past 30 years, the first four months were all consecutively positive six other times, averaging YTD returns of 10.59%. Notably, all six instances ended the respective year higher than the April-end level, with an average annual return of 25.10% (see Exhibit 1).

Both the S&P MidCap 400^® (18.5%) and SmallCap 600^® (15.4%) have had their best-ever start to the year through the end of April. Both mid and small caps were positive in April, rebounding after both were negative in March. Of the 11 sectors, 8 were positive in both the large- and mid-cap segments. Of the small-cap sectors, nine were positive. Financials was a top-performing sector, with the S&P 500 Financials the best at 8.84%. Health Care, Energy, and Real Estate were the bottom three sectors. The largest spread between size segments was within the Communication Services sector, with the large cap gaining 6.22% and small cap losing 2.15%. Additionally, value outperformed growth in all three size segments. Overall, 29 of the 42 segments of the U.S. equity market had higher returns in April compared with March, and only eight were negative.

Considering the historic YTD gains as the month of May begins, the common “Sell in May and Go Away” adage comes back into focus. Despite being somewhat of an investing axiom, it is a recurring debate. The over 90-year history of the S&P 500 can be used to evaluate historic results for the November through April and May through October periods. Overall, the S&P 500 averaged a 1.98% return in the May through October periods and was positive in 59 of the 90 periods.

Performance has tended to be lower in the May through October periods. Over the 90 years since Oct. 31, 1928, the S&P 500 on average returned 3.25% less in the May through October period compared with the preceding November through April period. The performance on average was lower, but there were 29 instances that the May through October period return was higher than the preceding November through April, including 15 instances that the November through April period was negative and May through October was positive. This compares to 21 instances when the November through April period was positive and the following May through October period was negative. Regardless of which was higher, there were 43 instances that both the November through April and following May through October periods were positive, and 11 instances that observed negative returns in both periods.

Throughout the ongoing bull market, the November through April period has outperformed the following May through October period by an average of 6.28%. The May through October period outperformed the prior November through April period only once (2016) and was negative three times (2010: -0.29%; 2011: -8.09%; 2015: -0.30%). However, the average return for the May through October periods remained positive, at 2.53%.

The S&P MARC 5% Excess Return (ER) Index started the year firing on all cylinders, with positive returns across all asset classes for the quarter—dimming memories of 2018, when all the underlying indices ended the year in red.

Its asset class diversification and weighting strategy helped the index to stay positive throughout the quarter, despite a slight dip early on in the equities market. For all asset classes, the main contributors to performance continued to be equities and fixed income, with gold ending the quarter relatively flat.

When comparing the component assets to the S&P MARC 5% (ER) Index to see what periods the components outperformed or underperformed the index, the story is similar. In the middle of the quarter, we saw gold pick up in performance, which, when combined with equities, helped to offset some of the lower relative performance on the fixed income portion.

Looking at the rolling 252-day performance, for the 61 days in the quarter, we can see that in January of this year, the 252-day return would have been negative. This was due to the strong performance of the index from December 2017 through January 2018, which drove the index levels higher until volatility entered the market in February 2018. The 252-day performance from February 2019 through the end of the quarter maintained a somewhat upbeat trend, with the overall quarter having 54% of the days positive.

Looking at the index allocations of the quarter, after the year-end volatility of 2018, the equity allocation of the index was exceptionally low, at just 12.4% to start 2019 when compared with the historical average of 22%. Despite this tempered start, the index ended the quarter at 20.8%, close to its historical average, and with an average over the quarter slightly above 16%.

Passive use of factor strategies began with growth and value style investing. S&P Dow Jones Indices now offers single- and multi-factor indices that provide exposure to growth, quality, value, momentum, size, yield, and low volatility factors.

Factors perform differently depending on market conditions, economic cycles, or investor sentiment. Timing factors can be difficult. Many market participants combine factors as a possible way to achieve portfolio diversification.

There are different ways to form multi-factor portfolios,[1] and in a relatively small market like the Mexican equity market, it can be challenging. To meet this challenge, we constructed the S&P/BMV IPC Quality, Value & Growth Index with a two-step process of constituent selection and weighting.[2] A bottom-up integration approach is used in order to increase overall exposure to the desired factors.[3]

The underlying universe is the S&P/BMV IPC, which is widely considered as the barometer of the Mexican equity market. Because this benchmark already incorporates liquidity measures, there’s no need for additional liquidity criteria when applying factor overlays.[4]

1. Step One – Constituent Selection: We calculate the quality, value, and growth z-scores for each of the eligible stocks in the universe. A security must have at least one fundamental z-score for each factor (quality, value, and growth) to be included in the index. A stock is ineligible if any of the factor scores are among the four lowest-ranked securities by factor.
2. Step Two – Weighting Mechanism: At each rebalancing date, all securities eligible for inclusion are weighted by their final multi-factor score weight, which is the simple average of the underlying quality, value, and growth scores.

The number of constituents in the S&P/BMV IPC Quality, Value & Growth Index varies. On average, it has had roughly 24 constituents from June 17, 2005,[5] to Dec. 21, 2018, while its benchmark, the S&P/BMV IPC, has had 35.

Due to the weighting mechanism, we find that the multi-factor index differs meaningfully from the underlying benchmark. The active share, calculated by taking the sum of the absolute value of the differences of the weight of the S&P/BMV IPC Quality, Value & Growth Index and the weight of each holding in the S&P/BMV IPC divided by two, was greater than 50% (see Exhibit 2).

Exhibit 3 compares the fundamental characteristics of the multi-factor strategy to the benchmark. On average, the multi-factor strategy had more desirable quality characteristics, with lower financial leverage and accruals ratios, as well as higher operating return on assets. It also had higher value characteristics than the benchmark.

Despite having fewer securities, multi-factor strategies are possible in Mexico. The requirement is that there are sufficient fundamental or valuation differences among the constituents.

[1]   Innes, Andrew, S&P Dow Jones Indices, “The Merits and Methods of Multi-Factor Investing,” 2018.

[2]   For further information, see the S&P/BMV IPC Quality, Value & Growth Index section in the S&P/BMV Indices Methodology.

[3]   Sanchez, Maria, S&P Dow Jones Indices, “Blending Factors in Mexico: The S&P/BMV Quality, Value and Growth Index,” 2019.

[4]   For further information, see the S&P/BMV IPC section in the S&P/BMV Indices Methodology.

[5]   The first value date of the S&P/BMV IPC Quality, Value & Growth Index is June 17, 2005. For more information, please see our website at https://spindices.com/indices/strategy/sp-bmv-ipc-quality-value-growth-index.

Tomorrow, Warren Buffett and 30,000 of his closest friends will gather in Omaha for Berkshire Hathaway’s annual meeting.  The loyalty of long-term Berkshire shareholders is the stuff of legend, as is the investment performance that produced it.  $100 invested in Berkshire stock at the end of 1968 would have grown to more than $850,000 by the end of 2018; a comparable investment in the S&P 500 would have grown to just under $11,000.

Berkshire’s wealth generation has been all the more remarkable for having occurred in an era when the majority of active portfolio managers underperformed unmanaged indices like the S&P 500.  Academics have naturally been interested in how such exceptional results arose, with some arguing that “Buffett’s Alpha” is actually “a reward for leveraging cheap, safe, high-quality stocks.”

Regardless of the source of Berkshire’s excess returns, it’s unquestionable that their magnitude has been on a downtrend.  There are 40 (overlapping) ten-year performance windows in our 50-year history.  In the first 20 of them, Berkshire beat the S&P 500 by more than 10% per year.  In the second 20, Berkshire’s margin of outperformance hit double digits only 3 times; the last such period ended in 2002.

In fact, Berkshire’s compound annual return lagged that of the S&P 500 in the 10 years ended 2018 – in which respect it resembles most active large-cap U.S. equity managers, more than 85% of whom underperformed in the last decade.  Warren Buffett was recently asked whether Berkshire or the S&P 500 would be the better investment for a long-term investor and did not hesitate to answer that “I think the financial result would be very close to the same.”

When the premier active investment manager in modern financial history says that, you know that active management is a very hard game – and getting harder.