Indexology^® Blog

Do you ever wonder where environmental, social, and governance (ESG) factors—now used in more than 25%[1] of all assets under management—come from? The short answer is: Mainly from the good-practices checklists maintained by a handful of big ratings agencies.

But where did those agencies get their checklists? Mainly from the fruits of a handful of turn-of-the-millennium sources, including John Elkington’s “Triple Bottom Line,” the “100 Best Companies to Work For” list, and the United Nations Principles for Responsible Investment.

But where did these sources come from?

Sixty-five years ago, Peter Drucker wrote in his landmark book, The Practice of Management, “What is most important is that management realize that it must consider the impact of every business policy and business action upon society.”

While Drucker would have applauded the rise of ESG investing, he would have encouraged it as one piece of a broader, holistic view of “social responsibility.” For Drucker, social responsibility begins with the customer. After all, he wrote, “it is to supply the consumer that society entrusts wealth-producing resources to the business enterprise.” Drucker also held that a corporation must take care of its employees, maintaining that if “worker and work are mismanaged” it is “actually destructive of capital.” He counseled that companies must constantly pursue innovation, not merely to grow revenue but in service of their basic function as society’s “specific organ of growth, expansion and change.” In all of this, Drucker was decades ahead of his time, anticipating an age in which 80% of a company’s value[2] would take the form of intangibles not shown on a balance sheet.

Not that Drucker considered financial strength unimportant. Business’s “first responsibility,” Drucker declared, “is to operate at a profit,” so as to fulfill its role as “the wealth-creating and wealth-producing organ of our society.” Ultimately, Drucker saw that social responsibility would be the highest expression of business purpose rather than a feel-good sideshow—a harbinger of today’s concept of “shared value” and the basis of the S&P/Drucker Institute Corporate Effectiveness Index. “It is management’s…responsibility,” Drucker wrote, “to make whatever is genuinely in the public good become the enterprise’s own self-interest.”

The evidence that investors and executives are still catching up to Drucker’s foresight is, sadly, all around. Pleas to fix capitalism before it breaks beyond repair aren’t only coming from dissatisfied workers and customers or political ideologues; they’re coming from the power elite at Davos and the Milken Institute.[3]

Here again, we find ESG’s roots in Drucker’s philosophy. Sixty-five years before today’s headlines about worried billionaires, Drucker wrote, “capitalism is being attacked not because it is inefficient or misgoverned but because it is cynical. And indeed, a society based on the assertion that private vices become public benefits cannot endure, no matter how impeccable its logic, no matter how great its benefits.”

The rising concern for capitalism’s social viability comes alongside booms in both ESG investing and ESG products and services. That’s no accident. In Peter Drucker, we have the same person to thank for laying ESG’s foundation, sounding the alarm about its importance, and prescribing it as a solution.

[1]   Bernow, Sara, Klempner, Bryce, and Magnin, Clarisse. “From ‘why’ to ‘why not’: Sustainable investing as the new normal.” McKinsey & Company. October 2017.

[2]   EY – The Embankment Project for Inclusive Capitalism Report.

[3]   Jaffe, Greg. “Capitalism in crisis: U.S. billionaires worry about the survival of the system that made them rich.” The Washington Post. April 20, 2019.

Despite the hovering cloud of geopolitical menace as we entered 2019, the U.S. equity market enjoyed an almost seamless rise through the first four months of the year. May’s retreat reacquainted investors with volatility and served as a reminder that the market is near all-time highs, having enjoyed a more or less sustained increase for 10+ years, and that any number of unpredictable circumstances could adversely affect the economy.  Should investors accordingly reduce equity exposure?

Three years ago we introduced the dispersion-correlation map as a guide to understanding market dynamics.  Exhibit 1 graphs each year’s average dispersion and correlation, along with the year’s total return for the S&P 500.  Dispersion, as the graph shows, tends to cluster in the neighborhood of 20%.  The exceptions to this rule are typically years of dramatic market action, including such meltdown years as 2000-03 or 2008.  In our (admittedly limited) data history, very high dispersion has been a necessary, but not sufficient, condition for very bad markets.  For the 12 months ended May 31, 2019, dispersion crept slightly higher than its long term median but is well below “very high” territory.

EXHIBIT 1: DISPERSION-CORRELATION MAPS (RETURNS)

All of the data in Exhibit 1 are 12-month averages.  Shifting to one-month data, Exhibit 2 compares May 2019 to the 24 months of two notably-bad years, 2001 and 2008.  The conclusion is the same – today’s dispersion level is well below those typically found in market meltdowns.

EXHIBIT 2: S&P 500 MONTHLY DISPERSION & CORRELATION

Last month, in collaboration with S&P Dow Jones Indices (S&P DJI), LinkUp launched the S&P 500® LinkUp Jobs Index and related sector indices. The Index measures labor demand for companies within the S&P 500 at an aggregate, sector, and individual company level and serves as an indicator of the health of the labor market and economy as a whole.

Because the Index is constructed from job openings in LinkUp’s job search engine that are sourced directly from corporate websites daily, it provides real-time insight into the labor demand of the 500 companies and their subsidiaries in the S&P 500. Using the Index and data behind it, Molly Moseley of LinkUp explored the recently announced Ford Layoffs in relation to the consumer discretionary sector as a whole. You can view more about the launch of the Index here. 

Discretionary spending is up in 2019. However, while people might be buying plenty of things, it appears cars aren’t on their must-have-it-now list.

Slow Q1 sales have been commonplace for major automotive retailers since 2016.  (See below chart.) As sales lag, it’s interesting that Ford just announced it will be laying off 7,000 people by the end of August. Most of the reductions are expected overseas, with an estimated 2,300 layoffs in the United States impacting mostly managers and other salaried employees, not hourly factory workers. Ford had similar layoffs almost exactly two years ago in an effort to reduce costs and run leaner overall.

Large layoffs like these can typically be seen in job opening data. Companies often remove job openings from their website and off their “books” in order to meet layoff goals. The graph below shows Ford’s job openings in relation to fellow automaker GM, in the context of the S&P 500® LinkUp Jobs Consumer Discretionary (Sector) Index in which it falls, within the S&P 500 LinkUp Jobs Index. You’ll see that while the S&P 500 LinkUp Jobs Consumer Discretionary Index from 2016 to date is up overall (gray line), job listings at Ford and GM are down (dotted lines).

If we look at Ford data specifically, it can provide interesting insights into the current scenario. In the below graph, Ford job openings are broken out by occupation. You can see that management positions (blue) decreased mid-2017 due to the layoffs two years ago. It will be interesting to see if the same decrease in management positions will occur this year due to the new announcements.

This close look at management positions over time makes it even easier to see the dramatic dip in 2017. Keep in mind, layoffs were announced in May that year.

Job listings data may provide insight into the health of a company today and what may be just around the corner.

After four consecutive months of gains by the S&P 500^®, the U.S. equity market broadly declined in May. The S&P 500, S&P MidCap 400^®, and S&P SmallCap 600^® declined 6.6%, 8.1%, and 8.9%, respectively. The primary catalyst was the renewed trade tension between the U.S. and China, which reversed course from the optimism coming out of March and April negotiations. On May 10, 2019, President Trump followed through on earlier threats to increase tariffs to 25% on USD 200 billion of Chinese products. This move was promptly thereafter reciprocated with tariffs raised on USD 60 billion of U.S. goods, effective June 1, 2019. Investors were left mulling the short- and long-term effects this would have on the global economy.

Large-cap Real Estate was the only segment of the U.S. equity market to post a gain in May. The 41 other U.S. equity segments were negative. The S&P 500 Real Estate finished May up 0.9%. The Real Estate sector consists of real estate investment trusts (REITs) and real estate management and development companies. The sector benefited in May from its relatively low exposure to foreign markets. Utilities, which was the best performer in May within the mid- and small-cap segments, was the only sector with lower average foreign revenue exposure than Real Estate. The Energy sector had the worst returns across all three size segments.

As of May 31, 2019, the Real Estate sector was the top-performing sector year-to-date. The price return of S&P 500 Real Estate year-to-date was 17%. The S&P 500 as a whole returned 9.8%. With strong price performance and an index dividend yield well above 3%, large-cap Real Estate was a clear winner through the first five months of 2019.

May 2019 marked the 11^th time since January 2009 that the U.S. equity market declined this broadly. In the 10 previous instances when only 1 or 0 of the segments across U.S. equities were positive for the month, the S&P 500 average return was -5.6%. Only twice did the S&P 500 fully recover in the immediately following month, although the index had a positive return for 6 out of 10, averaging 1.9%, with a maximum increase of 10.8% and decrease of 11.0% (see Exhibit 3).

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