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Index Construction Matters in U.S. Small Cap

S&P 500 Quality High Dividend Index In Volatile Markets

Happy Birthday to the Communication Services Sector

S&P High Yield Dividend Aristocrats Part III: Sector Composition, Performance Attribution, and Factor Exposure

Have Passive AUMs Eclipsed Active?

Index Construction Matters in U.S. Small Cap

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Aye Soe

Managing Director, Global Head of Product Management

S&P Dow Jones Indices

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Market participants generally expect risk/return profiles to be similar across broad market indices representing the same universe. However, indices’ risk/return characteristics can vary substantially. As of Aug. 31, 2019, the S&P SmallCap 600® returned 10.21% per year since year-end 1993, while the Russell 2000 returned 8.53%.

So why is there a substantial risk/return gap between the two small-cap U.S. equity indices? In 2009, S&P Dow Jones Indices published a study that highlighted the impact of the S&P SmallCap 600’s financial viability screen.[1] Requiring index constituents to have a history of positive earnings was meaningful in explaining the S&P SmallCap 600’s outperformance and its quality bias compared with the Russell 2000. A five-year update to the study confirmed these results: the S&P SmallCap 600 continued to outperform, driven predominantly by a quality premium.[2]

To celebrate the 10-year anniversary of the first study, we recently published another update to the research, looking into the differences in methodology between the S&P SmallCap 600 and the Russell 2000. In addition to the profitability criteria, we assessed the impact of two index inclusion criteria—liquidity and public float—that are present in the S&P SmallCap 600 but absent in the Russell 2000.

All else equal, small-cap companies (in the U.S. as well as around the world) with higher profitability, higher liquidity, and higher investability tend to earn higher returns than those with lower profitability, liquidity, and investability. Given the differences in index construction, these characteristics help to explain the potential performance advantage of the S&P SmallCap 600.

In light of the historical outperformance of the S&P SmallCap 600 compared with the Russell 2000, it is perhaps unsurprising that a greater proportion of active small-cap managers underperformed the S&P SmallCap 600 than the Russell 2000, historically. For example, using data from our SPIVA U.S. Year-End 2018 Scorecard, 78% of small-cap funds underperformed the S&P SmallCap 600 over three-year time horizons, on average. This compared with 62% underperforming the Russell 2000, on average, over the same periods. Exhibit 3 shows that the results were similar using five-year annualized returns.

As a result, market participants may wish to keep in mind the potential influence of index construction on risk/return characteristics: the outperformance of the S&P SmallCap 600 versus the Russell 2000 over the past 25 years highlights that not all benchmarks are created equal. Knowing key return and risk drivers of the small-cap market segment may present opportunities to capture broad market exposure while avoiding pitfalls inherent in the small-cap space.

[1]   S&P Dow Jones Indices defines financial viability as when the sum of the four most recent consecutive quarters’ reported earnings is positive, as well as those of the most recent quarter.
Soe, Aye and Srikant Dash, “A Tale of Two Benchmarks.” S&P Dow Jones Indices, July 2009.

[2]   Soe, Aye and Phillip Brzenk. “A Tale of Two Benchmarks: Five Years Later.” S&P Dow Jones Indices, March 2015.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

S&P 500 Quality High Dividend Index In Volatile Markets

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Qing Li

Director, Global Research & Design

S&P Dow Jones Indices

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The U.S. stock market has experienced a decade-long bull market since the global financial crisis. In fact, from March 9, 2009, to Sept. 6, 2019, the S&P 500® delivered a strong gain of 448% on a total return basis.

For market participants who fear an economic slowdown and a stock market pullback, the S&P 500 Quality High Dividend Index, a dividend strategy that incorporates a quality factor,[i] may aid in providing defensive characteristics.

Focusing on quality and dividend yield, the S&P 500 Quality High Dividend Index has delivered significant outperformance over the long term relative to the broader market. In nearly 25 years of history, the strategy produced an annualized return of 13.26%, compared with 9.89% from the overall U.S. equity market as indicated by the S&P 500 (see Exhibit 1). Taking volatility into consideration, the S&P 500 Quality High Dividend Index offered a risk-adjusted return of 0.94, which is 38% higher than that of the S&P 500.

Besides the superior long-term returns, the S&P 500 Quality High Dividend Index has sustained a consistently higher dividend yield. On average, the strategy offered a 2.9% dividend yield compared with its benchmark’s 2% during the 15-year horizon (see Exhibit 2).

Since its inception, the S&P 500 Quality High Dividend Index has demonstrated defensive characteristics by outperforming in down markets. Using monthly return data, we calculated upside and downside capture ratios to measure how the S&P 500 Quality High Dividend Index performed during up and down markets. The strategy’s 73.2% downside capture ratio indicates that if the broader market declines 10%, the S&P 500 Quality Dividend Index would fall 7.3%, or 27% less than the benchmark. On the other hand, the strategy captured 93.8% gains of the upside markets historically, indicating nearly full engagement in rising markets.

Exhibit 3 shows how the S&P 500 Quality High Dividend Index performed during the five most severe drawdown periods. The strategy topped its benchmark during all the turbulent periods and returned an average excess gain of 13.1%. The most noticeable performance occurred when the dotcom era ended on Sept. 1, 2002. While the S&P 500 tumbled more than 47% from its peak, the S&P 500 Quality High Dividend Index stayed in positive return territory and delivered 51.4% excess return over the benchmark.

Furthermore, when the broad market rebounded to its previous peaks, the strategy delivered higher returns during the same time horizons, as shown in Exhibit 4.

Through the combination of quality and high dividend yield, the S&P 500 Quality High Dividend Index captured the majority of the uptrend in markets but incurred less loss in down markets.

 

[i] Quality score is calculated using return-on-equity, accruals ratio, and financial leverage. Please refer to S&P Quality Indices Methodology for details.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Happy Birthday to the Communication Services Sector

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Anu Ganti

Senior Director, Index Investment Strategy

S&P Dow Jones Indices

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The Communication Services sector turns one year old on Sept. 24, 2019. A year ago, the Global Industry Classification Standard® (GICS®) replaced the old Telecommunication Services sector with a new Communication Services sector, which combined telecom with some companies that had formerly been classified in the Information Technology and Consumer Discretionary sectors. As a result, Telecommunication Services, once the ugly duckling comprising three stodgy phone companies, metamorphosed into a sector that included high-growth companies such as Alphabet, Facebook, and Netflix. Over the past 12 months, the sector outperformed the S&P 500®, up 8.55% versus the market’s 4.22%.

After this change, the average constituent volatility of Communication Services has been higher than that of the old Telecommunication Services. Some investors might therefore assume that the volatility of the new index is also higher than that of its predecessor, but this is paradoxically not the case. We predicted last year that the volatility of the new sector would be roughly the same as the old, resulting from the juxtaposition of two opposing forces: Communication Services’ higher dispersion, which drives volatility higher, is balanced by lower intra-sector correlations, which pull volatility lower.

A year later, our forecast has come to fruition. As seen in Exhibit 1, Communication Services’  average volatility (19.25%) is only slightly higher than that of Telecommunication Services (17.65%), and this increase came at a time when the S&P 500 overall was much more volatile. As predicted, Communication Services has higher average dispersion and much lower correlations than did Telecommunication Services.

Based on the data from Exhibit 1, we observe that the volatility of Telecommunication Services was 69% higher than that of the S&P 500 in the year prior to the GICS changes. Since then, the volatility of Communication Services has been only 23% higher than that of the market, implying that Communication Services is much more market-like than its predecessor. We can see this firsthand through the factor exposures in Exhibit 2. Telecommunication Services had a high exposure to dividend yield and value. In stark contrast, Communication Services tilts away from dividend yield and low volatility, as well as away from small size, and is relatively more exposed to momentum and high beta. As a result, the sector now behaves more like the market.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

S&P High Yield Dividend Aristocrats Part III: Sector Composition, Performance Attribution, and Factor Exposure

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Bill Hao

Director, Global Research & Design

S&P Dow Jones Indices

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In this blog, the third in our introduction to the S&P High Yield Dividend Aristocrats®, we will cover sector composition, performance attribution, and factor exposure.

Sector Composition

As shown in Exhibit 1, the S&P High Yield Dividend Aristocrats has diversified sector exposures, with some sector bets, given different dividend-paying practices among sectors. Historically, the S&P High Yield Dividend Aristocrats has had higher exposure to the Financials, Utilities, Consumer Staples, Industrials, and Materials sectors, in terms of absolute weight and weights relative to the S&P Composite 1500®. In contrast, the index has had much lower exposures to the Energy, Information Technology, and Health Care sectors.

Performance Attribution

We analyze the sources of the historical excess returns of the S&P High Yield Dividend Aristocrats versus the S&P Composite 1500. Grouping by sectors, we look at the sector allocation[1] and individual stock selection effects (see Exhibit 2).

Performance attribution shows that individual stock selection contributed to 75% of monthly active returns, while sector allocation contributed to 25%. Thus, the outperformance of the S&P High Yield Dividend Aristocrats mainly came from stock selection rather than sector allocation.

Factor Exposures

We used the Fama-French Five-Factor Model[2] to dissect the historical returns of the S&P High Yield Dividend Aristocrats (see Exhibit 3). From the factor loading estimates and associated t-statistics, we can see that the S&P High Yield Dividend Aristocrats constituents had positive exposures to lower beta, better value, higher operating profitability, and more conservative investment growth. Profitability and investment growth are considered to be quality factors.

The empirical results show that the constituents had better valuation and quality characteristics than the overall market. From business operations and financial perspectives, high quality fundamentals form the foundation for consistent dividend increase.

From our three-blog installment, we can conclude that the S&P High Yield Dividend Aristocrats has consistently had higher yields than its benchmark. Further, performance attribution and factor exposure analyses showed that the strategy’s outperformance was mainly due to stock selection and that its constituents have had good value and quality characteristics. In return, such solid fundamentals have driven its long-term favorable risk-adjusted returns and defensive characteristics.

For more information, see the two previous blogs in the installment.

[1]   The sector allocation effect is the portion of portfolio excess return attributed to taking on sector bets in comparison with the benchmark. Individual stock selection effect is the portion of portfolio excess return attributable to individual stock selection when the sector weight is the same as that of the benchmark.

[2]   Fama, E. and K. French. “Dissecting Anomalies with a Five-Factor Model.” The Review of Financial Studies, Volume 29, Issue 1, 2016, pp. 69-103.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Have Passive AUMs Eclipsed Active?

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Craig Lazzara

Managing Director and Global Head of Index Investment Strategy

S&P Dow Jones Indices

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“You all did see that on the Lupercal
I thrice presented him a kingly crown,
Which he did thrice refuse.”

Julius Caesar, Act 3

This morning’s Wall Street Journal declared that “Index Funds Are the New Kings of Wall Street.”  The coronation, and similar notes of the “end of an era,” were prompted by Morningstar data showing that, for the first time, the assets invested in index-tracking mutual funds and ETFs exceed the AUM of actively-managed funds which aim to outperform.  As index providers, we’re gratified to see the extent of investor acceptance of our services, but, like Caesar, we renounce the crown.

In any event, it’s important to understand the extent of our putative domain.  The Morningstar data are based on mutual fund and ETF assets under management.  This is a popular data set because it’s easy to access – funds are legally required to report their AUM.  Pensions, endowments, individuals, etc. have no such requirement, at least not on a continuous basis.  As the WSJ article notes, indexed mutual funds, though 50% of mutual fund and ETF assets, account for only 14% of the value of the entire U.S. equity market.

This estimate is consistent with our own research, which suggests that indexing amounts to between 20% and 25% of the U.S. equity market.  Even this lower figure is remarkable given that index funds did not exist 50 years ago; the growth of indexing surely counts as one of the most significant developments of contemporary financial history.

Indexing started because active management overpromised and underdelivered, as our SPIVA reports have consistently demonstrated.  The challenges to active management in the last 50 years are arguably a product of its success in the decades prior.  Active investing is intrinsically a zero-sum game; the only source of outperformance for one investor is the underperformance of another.  As they came to dominate global markets, it became impossible for professional investors as a group to deliver above-index performance.

As indexing has grown, the benefits to investors – in terms of underperformance avoided and fees saved – have been substantial.  The bars in the chart above show the growth of assets tracking the S&P 500, S&P MidCap 400, and S&P SmallCap 600.  As of December 2018, those assets totaled nearly $3.9 trillion.  The green line represents our estimate of the cumulative savings in management fees over the past 23 years; the savings cumulate to $287 billion.

The posts on this blog are opinions, not advice. Please read our Disclaimers.