Indexology^® Blog

The S&P/TSX 60 gained 15.5% YTD[i] and many companies included in the index have benefitted from business prospects in the U.S. While nearly all stocks in the index are domiciled in Canada, 49%[ii] of combined revenues come from within Canada’s borders, while another 30% are sourced in the U.S. As shown in Exhibit 1, stocks with significant U.S. exposure have outperformed, contributing to gains of the S&P/TSX 60.

The S&P/TSX 60 U.S. Revenue Exposure Index, which is designed to measure companies from the S&P/TSX 60 with higher than average exposure to the U.S., outperformed the benchmark by 5.8 percentage points YTD. Meanwhile, the S&P/TSX 60 Canada Revenue Exposure Index, which is designed to measure companies from the S&P/TSX 60 with higher than average exposure to Canada, underperformed by 1.5 percentage points as of May 27, 2019.

Sector weight variations of each index, as shown in Exhibit 2, help explain the recent performance differences. Canadian Financials and Communication Services companies tend to gain a larger proportion of revenues from domestic sources. Energy and Information Technology companies, meanwhile, gain greater revenues outside of Canada.

Greater domestic focus of Communication Services and Financials sectors—shown in Exhibit 3—have been a hindrance to the S&P/TSX 60 Canada Revenue Exposure Index in 2019. Meanwhile, the outperformance of Energy and Information Technology companies have led to the improved returns of the S&P/TSX 60 U.S. Revenue Exposure Index.

While the S&P/TSX 60 comprises top companies in leading Canadian industries, over half of combined revenues are sourced from outside the country. Those companies earning significant revenues outside of Canada have boosted the YTD gains of the flagship index.

[i]   Source: S&P Dow Jones Indices LLC, total return data in CAD as of May 27, 2019.

[ii]   Source: Revenue exposure data from Factset, LLC, data as of May 27, 2019.

Australian Listed Equities

The Australian listed equity market has two characteristics not to be overlooked when constructing a domestic index: its relatively small number of stocks and relatively large exposures to a few specific sectors. These factors alone often mean that the application of a specific indexing methodology can produce more pronounced effects compared with the equivalent approach being applied to a global universe.

1. Number of Constituents

The S&P/ASX 200’s relatively low number of companies imply that each company has a larger-than-average weight in the index for a given size. Therefore, any exclusionary indexing approach could cause relatively larger levels of tracking error and index volatility compared with more diversified benchmarks.

This indeed turns out to be the case. The S&P 500 ESG Index—an index with more constituents of lower average index weights—had a marginally higher standard deviation than the benchmark over five years, at only 0.03%, compared with the S&P/ASX 200 ESG Index’s larger 0.23% margin (see Exhibit 1). The Australian benchmark also had a higher five-year tracking error than its U.S. counterpart.

Companies in the S&P ESG Indices are selected for inclusion, targeting 75% of the eligible universe’s weight, at the GICS^® industry group level. However, by looking at the sector-level proportions of benchmark market caps covered in the ESG index compared with the 75% target, some sectors over- or undershoot the target by a significant margin.

These margins in all but two sectors are larger for the S&P/ASX 200 ESG Index than for the S&P 500 ESG Index, which may be expected given the relatively higher weights of the average stock in the Australian index. The marginal inclusion of comparatively smaller-weighted stocks, on average, would likely leave the final industry group market capitalization closer to the 75% target. The same result can also be expected when considering coverage at the sector level (see Exhibit 2).

2. Sector Concentrations

Any index benchmarked to the S&P/ASX 200 would also be sensitive to how its methodology treats companies in the Financials (32.10%), Materials (18.12%), Health Care (8.40%), and Industrials (8.22%) sectors due to their significant weights.[1]

The S&P/ASX 200 ESG Index’s sector weights differ slightly from their weights in the benchmark due to the exclusions made when defining the index’s eligible universe. The two largest sector weight differences are found within the Health Care and Financials sectors.

• In April 2019, Health Care had a 2.26% larger sector weight in the S&P/ASX 200 ESG Index compared with benchmark.
• In contrast, Financials was underweight in the S&P/ASX 200 ESG Index by 2.81 (see Exhibit 3).

The S&P/ASX 200 ESG Index – Index Performance

Despite some of the nuances of the Australian listed equities market described above, the S&P/ASX 200 ESG Index achieves its objective. The index delivers a substantial index ESG score improvement, while providing a benchmark-like risk/return profile.

In fact, for the period studied, the S&P/ASX 200 ESG Index provided better relative returns and index ESG score improvement compared with its benchmark than its U.S. counterpart (see Exhibit 4). Overall, the S&P/ASX 200 ESG Index had an index ESG improvement of 28% compared with benchmark, while providing the same five-year annualized returns.

The ESG improvement at the sector level ranged from 14% to 66% (see Exhibit 5). The Real Estate and Consumer Discretionary sectors’ ESG score improvements were the largest. In the case of the Consumer Discretionary sector, this large improvement might have been expected considering that the ESG index’s coverage of the eligible benchmark sector market cap was the lowest (63%, see Exhibit 2). This implies that the average company included in this sector was among the higher ESG scoring samples in the top of the distribution of eligible companies. Similarly, the relatively low level of ESG score improvement experienced by the Utilities sector was correlated with its overshooting of the 75% benchmark market capitalization target.

CONCLUSION

The S&P/ASX 200 ESG Index is designed to present the Australian equities market with an alternative and investable ESG option to the widely adopted S&P/ASX 200. It can provide an increased exposure to the companies with better ESG characteristics in the S&P/ASX 200, with a similar risk/return profile. By bringing this ESG strategy to the flagship benchmark, investing through an ESG lens has never been easier.

For more information on the S&P/ASX 200 ESG Index, please visit https://spindices.com/indices/equity/sp-asx-200-esg-index-aud

Additional Resources on the S&P ESG Index Series

• FAQs: S&P ESG Index Series
• Steadman, Reid, and Perrone, Daniel. “The S&P 500^® ESG Index: Integrating Environmental, Social, and Governance Values into the Core.” S&P Dow Jones Indices. April 2019
• The S&P ESG Index Series Methodology
• Part One of this Blog

[1]   Weights denote these GICS sector weights in the S&P/ASX 200 as of the adjusted close on April 30, 2019.

Although there seems to be more research on economic forecast and market analysis than manager selection, selecting investment managers is just as challenging as direct investing and requires considerable experience and expertise. In this blog, we investigate the return distribution of fixed income and equity funds to highlight the challenge of successfully selecting outperforming active managers. Specifically, we incorporate risk-reward analysis by calculating the ratio of the median of positive excess returns over the median of negative excess returns. This ratio provides an intuitive comparison between the magnitude of upside gains and downside losses from selecting outperforming versus underperforming active managers. All else equal, the common belief is that a ratio greater than or equal to two is desirable.

The underlying data for the analysis comes from our headline SPIVA^® U.S. Scorecard, which uses the University of Chicago’s Center for Research and Security Prices (CRSP) Survivor-Bias-Free US Mutual Fund Database, the only complete database of both active and liquidated or merged mutual funds. The analysis focused on funds’ return distribution, and therefore eliminated funds that had missing returns for the entire reporting period.

Exhibits 1 and 2 show 5-year and 10-year net excess return distributions for equity and fixed income managers by category. We calculated excess return as the net-of-fees return of each fund subtracting its relevant benchmark index return.

The following are the key highlights from the exhibits.

1. Equity managers had a harder time beating the benchmark than bond managers. The blue shade indicates the quartiles with positive net excess returns. For fixed income categories such as investment grade short and intermediate funds, global income funds, and municipal bond funds, more than half of the managers delivered positive excess returns. On the other hand, in most of the equity fund categories, except large-cap value funds, even top quartile managers were unable to outperform the benchmarks in both 5- and 10-year periods.
2. No equity funds were able to demonstrate a risk-reward ratio greater than one. The yellow shade highlights risk-reward ratios greater than two. California municipal debt funds stood out as the only fund category for which the median upside of selecting outperforming managers doubled the median downside of selecting underperforming managers for both 5- and 10-year returns. In contrast, no equity manager had a ratio greater than one.
3. Fixed income funds returns were more tightly clustered than equity funds. The interquartile range is a measure of statistical dispersion, calculated as the difference between the first and third quartile. In our case, it measures the range of alpha generated by the middle half of the managers within each fund category. The pink shades indicate that the interquartile range greater than 2% were more common for equity funds.

Consistent with prior research by S&P Dow Jones Indices,[1] we found that on a net-of-fees return basis, average managers did not outperform the benchmark over mid- to long-term horizons across all equity fund categories and many bond fund categories. Furthermore, the risk-reward analysis for picking outperforming managers versus underperforming ones demonstrated the challenge of manager selection and the expertise required to be successful in this field.

[1]   https://spindices.com/documents/spiva/spiva-us-year-end-2018.pdf

Passive investment is emerging as the more viable and favorable option over active investing. Recommendations for passive investing are supported by statistics. The S&P Dow Jones Indices SPIVA^® Around the World Report for year-end 2018 (see Exhibit 1) highlights the trend of benchmark indices beating active funds.

Exhibit 1: SPIVA Year-End 2018 Results

Source: S&P Dow Indices LLC. Data as of Dec. 31, 2018. Past performance is no guarantee of future results. Chart is provided for illustrative purposes.

In India’s significant growth economy, with lower inflation, higher GDP, and a robust financial market, there is recognition that the number of large-cap active funds underperforming their benchmark index is growing. The SPIVA India Year-End 2018 Scorecard revealed that 92% of large-cap funds underperformed the S&P BSE 100 over the 1-year period, 91% underperformed over the 3-year period, and over 50% underperformed over both the 5- and 10-year periods. The challenge for active fund managers to deliver superior returns is on the rise.

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.

Investors are adopting new dynamic approaches to portfolio management in order to align themselves with targeted portfolio goals. Passive investment objectives are driven by strategy and risk/return profiles.

The passive strategies to select from are manifold: value, growth, fundamental, technical, dividend, indexing, tactical, core, satellite, etc. Asset allocation in the strategy seeks to balance risk and reward by assigning the ideal weights of assets in the portfolio to meet the requirement of the end objective. Strategies vary along a spectrum, from aggressive to conservative.

The selection made on the risk/reward spectrum determines the strategy. Reward, or return, is the change in the value of the investment measured in percentage or in absolute terms like appreciation in stock price or receipt of dividends. Risk is measured by standard deviation, which expresses the volatility of the stock or portfolio by variance from the average. If an investment portfolio has an average expected return of 12% with standard deviation at 5%, the range of returns is expected to be between 7% and 17%.

Modern Portfolio Theory (MPT) is a preferred strategic tool that uses diversification to select a group of assets that offer maximum return for a given level of risk. Harry M. Markowitz in 1952 famously explained the relationship of risk and reward through his article “Portfolio Selection” in the Journal of Finance. He became the pioneer of MPT, also referred to as the Markowitz model.

MPT assumes that investors are generally rational and risk averse. The time horizons for risk and return are the same. The views on risk measurement are identical for all investors and they control risk by diversifying their holdings. The investor prefers to either maximize his return for minimum risk or maximize his portfolio return for a given level of risk.

The theory compares two portfolios with the same return expectation, but one has lower risk than the other. MPT shows that the preference is for the portfolio with lower risk. MPT also clarifies that diversification reduces the portfolio risk. MPT supports the case for the passive investing. This style inherently provides a diverse basket of stocks, avoiding concentration risk and offering returns at the chosen risk level.

Standard deviation typically is used to help evaluate investment risk options. If an index offers a lower standard deviation than an active strategy, but with a comparable average return, the choice of preferable investment option should be easy.

A range of indices offer varied strategies across geographies, asset classes, themes, and factors. Index methodologies are transparent and rules based, staying true to style, unlike active management, which can use discretion in striving to achieve objectives. Passive investing is also generally lower in cost, owing to lower fund management fees and ease of trading, as the index constituents trade on the stock exchange like regular equity stocks.

The Indian passive investment industry is gaining strength with over USD 16 billion in assets. Core satellite strategy can facilitate the co-existence of both active and passive styles to meet portfolio goals.

S&P Dow Jones Indices produces a semi-annual report comparing the performance of active managers to their target indices or benchmarks. The report is referred to as the SPIVA Scorecard (SPIVA standing for S&P Indices Versus Active Managers).  So, what does the SPIVA Scorecard tell us about performance?  As illustrated in the table above, for any regional equity class and over any timeframe, it tells us that the overwhelming majority of Canadian active managers fail to beat their benchmarks.

This underperformance can be attributed to two main factors: 1) information efficiency and 2) high portfolio management fees. Historically, “stock pickers” were often able to beat their target indices.  This was accomplished through rigorous analysis of privileged financial information and interviews with senior management.  However, he advent of the Internet and new regulations with respect to selective disclosure has levelled the playing field.  Today critical corporate information is readily available to all investors without privilege and at little expense.  As a result, market pricing has become “efficient”.  There is very little that an active manager can determine about the investment prospects for a large cap stock that the market doesn’t already know. At the same time, active managers typically charge investment management fees in the 1% range.  Portfolio turnover is often 50% to 100% or more, in any given year, further raising investment costs and eating into overall portfolio returns.

The end result, as illustrated in the performance data, is that active management of large cap liquid equities is no longer effective.