Indexology^® Blog

This is more an eyewitness account than an analytical review of the growth of indexing since I joined S&P in 1982.

The growth in indexing in the 20 years from S&P 500 futures in 1982 to the bottom of the tech bear market in 2002 was just a warm up. Two trends encouraging index growth reached critical mass in the 2000s: ETFs with low fees and attractive performance combined with the rise of discount brokerage. Discount brokerage began in 1975 when fixed commission rates ended. The earliest online brokers dated from 1991. In the aftermath of the tech bust investors were concerned about fees, wanted transparency and diversification – demands that ETFs and discount brokerage could meet.

The number and variety of indices broadened as well.  The S&P Midcap 400 and S&P Small Cap 600 joined the S&P 500 in the 1990s. Reaching beyond the home market, S&P adding the IFC emerging market indices in 1997. Next came exchange agreements in Canada and Australia in 1998 and 2000 and the BMI global equity indices in 2003.

In 1999, S&P and MSCI developed the Global Industry Classification Standard (GICS) to give investors a consistent way to categorize companies into sectors and industries.  With GICS, an analyst following the S&P 500 could know how much the market rose and what industries or sectors drove the gains. Using indices defined by GICS, she could choose which sector to invest in or how to re-weight the sectors in the S&P 500.

Indexing was never limited to equities and stock markets. S&P’s first bond indices designed to support ETFs were introduced in 2000 covering municipal bonds. In 2006, S&P began working with Robert Shiller, Yale economics professor, to publish indices on home prices in selected cities around the US. The indices, now known as the S&P Corelogic Case-Shiller Home Price Indices, became a key benchmark of home values during the financial crisis.  A year later in 2007 S&P acquired a leading commodity futures index, S&P GSCI, from Goldman Sachs.

The Global Financial Crisis and Great Recession of 2007-2009 gave us the second 50% bear market this century.  The S&P 500 fell 56.8% from October 9, 2007 to March 9, 2009. In the aftermath of a bear market some promise never to invest in stocks again, others look for new ways to build an index.

Factor indices were one new way. Rather than select stocks by size or sector, factor indices identify factors that affect stock performance and design indices which include desirable factors. One factor index introduced in response to the bear market and the financial crisis was the S&P 500 Low Volatility Index. As the name suggested, it is intended to be less volatile – maybe less worrisome – than the S&P 500.  Many others followed.

With the development of factor indices, index providers mounted a new challenge to active management and stock picking.  The initial thrust of indices was tracking the entire market with minimal expense. Investors benefited because few managers seemed to consistently pick the right stocks. The goal of factor indices is two-fold: adopt strategies based on the same academic research active managers follow combined with the lower expense structures of ETFs tracking indices. Many indices S&P DJI introduces today build on factors and similar strategies.

A major event for both S&P Indices and Dow Jones Indexes was joining two major index groups in 2012. Together they became S&P Dow Jones Indices bringing the two best-known equity indices – the Dow Jones Industrial Average and the S&P 500 – into the same organization. The DJIA traces its history back to 1896 and a predecessor index to 1884.  The S&P 500 became 500 stocks in 1957 when it was developed from an earlier index, the Standard Statistics 90 Stock Index that started in 1926.

The market has changed a lot since S&P 500 futures started. The number of listed equities in the US peaked in 1997 at about 7500; today there are slightly less than 4000 stocks.  The recent corporate tax cuts may encourage some limited partnerships to convert to C-corporations adding some larger names to the market. Due to the tech booms of the 1990s and the last ten years, some of the names at the top of the S&P 500 are relatively youthful and joined the index recently: Google joined the index in 2006, Amazon in 2005 and Facebook in 2012. Two older tech names are Microsoft added to the S&P 500 in 1994 and Apple added in 1982. Berkshire Hathaway joined in 2009 when it acquired Burlington Northern and split its class B stock. Currently the five biggest names in the S&P 500 do not include any banks or oil companies.

Estimates of the percentage of the US equities in index portfolios, funds and ETFs vary from 15% to almost 50%.  Indexing is here to stay and is likely to grow further.  We will never see a time when the whole market is indexed. More importantly, as indices based on factors, sectors, ESG requirements and other approaches join float adjusted market cap indices there will be no less diversity in the market. One factor index will rebalance out of a stock while another rebalances into the same stock.

Part 1 covered the period from 1982 to 2002

This is more an eyewitness account than an analytical review of the growth of indexing since I joined S&P in 1982.

At the beginning of 1982, few people saw indices as a business. There were only two well-known US indices – the S&P 500® and the Dow™ – and one index fund. Interest rates and inflation were in double digits and the economy was in the second of two back-to-back recessions. No one wanted to buy stocks.

That January the Chicago Mercantile Exchange (CME) began trading futures on the S&P 500. In August the Fed backed away from tight money, T-bills fell under 10% and bull markets in stocks and bonds began. Stocks didn’t peak until 2000, after a nasty moment in October 1987. Bonds may not have peaked yet. By the end of 1982 Wall Street was using the S&P 500 futures to hedge positions and indices weren’t just for promoting newspapers. In 1983, the Chicago Board Options Exchange (CBOE) began trading options on the CBOE 100 stock index under the ticker OEX, later the index became the S&P 100.

Indices were a small part of S&P. In 1983, there were about 10 people in the index group when its name was changed to Index Services from Research. Today “the S&P” means the S&P 500. In 1983, the initials meant S&P Stock Reports – one page stock recommendations.  S&P had many more people supporting active managers and stock pickers than working on indices.

Black Monday was October 19, 1987, the day the market crashed. From January to late August 1987, the market rose 37%; from the high to October 16, it dropped 16%. On Monday, October 19, the S&P 500 lost 20%. The Dow lost 22%. Then it recovered: The S&P 500 closed 1987 unchanged for the year.  The one-day drop on October 19 was greater than the crash of 1929, which took two days.

In 1980s, trading stocks became an American pastime and part of daytime television with Financial News Network, acquired by CNBC in 1991. The S&P 500 became the benchmark and scorekeeper for the markets. Investment banks hired analysts to track indices and companies started asking how to become part of the S&P 500.

The 1990s started with a recession as the market that fell 23% from July to October 1990.  At the American Stock Exchange (later acquire by the NYSE) the new products team, looking for ways to increase trading volume, dug into the SEC’s report on the 1987 crash. Buried in the report was a comment that a mechanism to execute a single trade for a basket of stocks or an index would have helped. From that thought came the “Big SPDR” – the first US exchange traded fund (ETF) launched in 1993.  The ETF tracked the S&P 500; SPDR stood for Standard & Poor’s Depository Receipts.

The ETF brought several innovations to investors: It could be bought and sold through any broker and traded any time the market was open. ETF fees are typically lower than actively managed mutual funds.  ETFs are designed to track an index and the index gives investors transparency into strategy and securities.

The Tech bull market that began in 1995 put indices on the map. Most tales of the tech boom-bust chronicle the insanity of the boom exemplified by Pets.com (a real company). There were other, more substantial companies, pushing the market higher.  Two internet pioneers, which met the S&P 500 requirement for positive earnings, were added to the S&P 500: America Online (AOL) in December 1998 and Yahoo in December 1999.  Both are now part of Verizon.

The bull market paused in 1998 when Russia defaulted of its debt in August and Long Term Capital Management, an aggressive hedge fund, collapsed in September. Stocks dropped 19% before rebounding. The end of the Technology bull market came on March 24, 2000. From then until October 9, 2002 the market fell 50%.

The Tech bust had a lesson for investors. Weighting an index by companies’ market caps is a natural approach – the market itself is cap weighted so the index return and the market return should match. The Tech Boom-Bust proved that on the way up cap weighting can be a strong momentum performer. On the way down after the market turns, the index is often over-weighted in the stocks with the most to lose.  S&P began exploring other ways to weight indices.

In January 2003, S&P launched an equal weighted version of the S&P 500. Rather than weighting stocks by market value, the index weights each stock equally. Compared to the standard S&P 500, the equal weight version over weights the smaller stocks and under weights the larger ones. From January 2003 to May 2019, the equal weight S&P 500 returned 9.2% per year compared to 7.3% per year for the cap-weighted version.

The weighting in the standard S&P 500 shifted to float adjusted market capitalization in 2005. With the increasingly popularity of indices, investors recognized that excluding closely held shares which rarely trade would make tracking an index with an ETF easier. The average float among S&P 500 stocks was over 90% and the index had always excluded stocks with a float less than 50%, so there was not a major impact from float adjustment.

See Part 2 on the time since the Tech Bust.

There was a notable reversal of fortunes across the commodities complex in May. The S&P GSCI was down 8.2% for the month but remained up 8.5% YTD. The Dow Jones Commodity Index (DJCI) was down 3.6% in May and up 3.7% YTD, reflecting its lower energy weighting. A sharp correction in petroleum prices combined with ongoing weakness in industrial metal prices weighed on the broad commodities indices’ performance over the month. The U.S. Administration’s penchant for utilizing trade restrictions as a negotiation tool for everything from lowering illegal immigration, to penalizing the unauthorized use of intellectual property, to reestablishing dominance over its closest neighbors has undoubtedly muddied the fundamental supply and demand dynamics of the majority of commodities markets.

Oil prices fell abruptly in May, as trade wars fanned fears of a broad economic slowdown. The S&P GSCI Petroleum dropped 13.8% in May, when the supply issues that had preoccupied the energy markets for much of the year gave way to concerns regarding the resilience of demand and the long-term implications of the reinvigorated trade dispute between the world’s two largest economies, the U.S. and China. Oil market participants will now turn their attention to the upcoming OPEC meeting, scheduled for June 25, 2019, where it is becoming increasingly likely that there will be an agreement among the OPEC+ members to continue, or even deepen, production cuts with the lofty goal of maintaining global oil market stability.

The S&P GSCI Industrial Metals gave back all of its YTD gains in May, falling 5.5% for the month. The S&P GSCI Copper and S&P GSCI Zinc led the way down, falling 9.1% and 9.2%, respectively, in May. These two metals are highly correlated with trade war sentiment, which deteriorated markedly over the month. Zinc continued to fall from its highs in Q1 2019 after revised expectations for a supply surplus this year, with China’s zinc output forecast rebounding by 5.3%. Associated with the trade war, heightened risks of a global growth slowdown also weighed on industrial metals, with China’s manufacturing PMI reading below expectations at 49.4 in May.

With the present ambiguity across commodity and equity markets, it is somewhat surprising that gold only attracted lackluster interest from investors in May. The S&P GSCI Gold was up 1.7% over the month, leaving its YTD performance only marginally positive. The U.S. dollar slowed its year-long appreciation, moving sideways in May and adding to the list of reasons why the gold market has been relatively featureless.

The S&P GSCI Agriculture rallied 9.7% in May. Having severely lagged the energy and industrial metals markets during the first four months of the year, a spark was lit under the grain markets in May. Wet and rainy conditions have severely delayed the grain planting season in the U.S., and this encouraged a level of excitement in the markets that has not been witnessed for a number of years. The most recent USDA crop report showed that only 58% of the corn crop had been planted by May 26, 2019, down from 92% last year and from the 90% five-year average. Both the S&P GSCI Corn and S&P GSCI Wheat were up 18% for the month. In contrast, the S&P GSCI Cotton fell 11.1% in May, plagued by the trade conflict between China and the U.S. China is the largest importer and user of raw cotton and the U.S. is a top buyer of Chinese textile products.

The frenzy in the grains market spilt over into the livestock markets in May, but with the opposite effect, given that grain is a major component of livestock feed. The S&P GSCI Livestock was down 6.5% in May.

Coming into month-end, and as the street prepares its monthly summaries, (all figures are as of May 29^th), the S&P 500 looks set to complete the month with a loss of around 5%.  So, what went wrong?  Global markets started the year very positively: the S&P 500 was up 18% by the end of April, while the S&P Global BMI had gained 16%.  Yet, the adage to “Sell in May and go away” looks to have been prescient advice this year.  Macro themes have returned, driving a wide spread in sector, factor, and country performances; volatility has also returned … although not as significantly as you might think.

Macro fears

The ongoing trade dispute between China and the United States provided the dominant theme in May, as both sides dug in their heels and prepared for a prolonged battle – creating uncertainty in both the investor and business communities.  Bond markets in particular demonstrated the flight to safety, as the 10-Year U.S. Treasury yield hit a twenty-month low, closing at 2.24%, and the 10-Year German Bund yield dropped to -0.18%.  Further, despite the U.S. economy growing 3.2% in Q1, the inversion in the U.S. yield curve continued to strengthen, stirring fears of recession.  While the current backdrop of economic strength seems like an unlikely environment for additional monetary stimulus, some believe there will be a rate cut from the U.S. Federal Reserve later this year – which added to the degree of inversion in the belly of the curve.

Divergence

While the broader market declined, sector, factor and single-country performances provided opportunities for selective investors.  Broadly speaking, defensive sectors outperformed, while trade-sensitive sectors struggled.  The S&P 500 Information Technology and Materials sectors declined 8% and 7%, respectively, while the Energy sector dropped 9% on oversupply concerns coupled with slowing global demand.

As was the case in sectors, defensive factors came back in vogue, with Low Volatility leading the way and High Beta bringing up the rear.  Momentum outperformed, which sounds counterintuitive but actually makes sense when you consider the timing of the mid-March rebalance for the index, when defensive constituents boasted market-beating one-year trailing returns.

In aggregate, markets included in the S&P Developed BMI outperformed those in the S&P Emerging BMI, but single-country performances were particularly dispersed.  Unsurprisingly, given the trade uncertainties, China struggled, with the S&P China BMI declining 12%.  Indian equities rebounded following the confirmation that Prime Minister Modi would get a second term, gaining 0.3% and outperforming all other Emerging Market country equity markets except for Russia and Greece, which gained 2% and 1%, respectively.  Frontier market Argentina beat them all, gaining 15% (all figures in USD terms).

Volatility … or a lack thereof

VIX® closed last night at 17.90, higher than it has been recently but not high by historical standards.  Given the perceived panic of trade concerns, it feels surprising that VIX isn’t higher.  One perspective is that the divergence in the performance among market segments has improved the level of diversification in the S&P 500; or it could be that – despite the cruelty of May – market participants think we’ll weather the storm and get back to growth in June.

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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.