Investment Themes

Sign up to receive Indexology® Blog email updates

In This List

The Outperformance of S&P and Dow Jones Islamic Market Indices versus Conventional Indices through Q3 2019

Unicorns: Only in Fairy Tales

S&P Risk Parity Indices: Positioning for Uncertainty

Factor Analysis of U.S. Small-Cap Benchmarks

Does Size Affect the Active versus Passive Score of Small-Cap Mutual Funds?

The Outperformance of S&P and Dow Jones Islamic Market Indices versus Conventional Indices through Q3 2019

Contributor Image
John Welling

Director, Equity Indices

S&P Dow Jones Indices

two

Developed Market Indices Lead, Emerging Markets Lag the Broad Market

Global S&P and Dow Jones Shariah-compliant benchmarks outperformed their conventional counterparts YTD in 2019, as Information Technology—which tends to be overweight in Islamic indices—continued to lead the sectors, while Financials—which is underrepresented in Islamic indices—continued to underperform the broader market. The S&P Global BMI Shariah and Dow Jones Islamic Market (DJIM) World gained 19.1% and 18.7%, respectively, outperforming the conventional S&P Global BMI by approximately 300 basis points.

The outperformance trend played out across major regions, as Shariah-compliant benchmarks for U.S., Europe, Asia-Pacific, developed, and emerging markets each outperformed conventional equity benchmarks by meaningful margins. The Pan Arab region was the lone exception, with the S&P Pan Arab Composite Shariah underperforming the conventional regional index.

U.S. Equities Continued to Lead the Rest of World through Q3 2019

Despite ongoing U.S.-China trade policy concerns, positive U.S. equity performance continued throughout Q3 2019, leading conventional global equities YTD. Strong earnings early in the quarter combined with a rate cut by the Federal Reserve contributed to gains. Regionally, European equities followed in performance, with double-digit gains over the period.

MENA Country Results Varied

MENA equity returns (in USD) suffered losses in Q3 2019 (-4.3%), as measured by the S&P Pan Arab Composite. However, its YTD return mimicked broad emerging market benchmarks, with a gain of 7.6%. The S&P Bahrain BMI continued to lead the region YTD, with a gain of 30.5%, followed by the S&P Egypt BMI, which added 26.5%. The S&P Kuwait BMI, which was promoted to emerging market status, gained 16.3% YTD, joining other emerging market countries such as Egypt, Qatar, Saudi Arabia (promoted in March), and the UAE. The S&P Qatar BMI lagged the most, falling 0.1% YTD.

Varied Returns of Shariah-Compliant Multi-Asset Indices

The DJIM Target Risk Indices—which combine Shariah-compliant global core equity, sukuk, and cash components—generally underperformed the S&P Global BMI Shariah and DJIM World YTD. Performance of the comparably more risk-averse DJIM Target Risk Conservative Index was constrained by its 20% allocation to global equities in the expanding market environment, ultimately gaining a favorable 11.0% YTD. Meanwhile, the performance of the DJIM Target Risk Aggressive Index was driven by its 100% allocation to a mix of Shariah-compliant global equities, returning 18.8%, in alignment with the broader S&P Global BMI Shariah and DJIM World.

For more information on how Shariah-compliant benchmarks performed in Q3 2019, read our latest Shariah Scorecard.

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

Unicorns: Only in Fairy Tales

Contributor Image
Chris Bennett

Director, Index Investment Strategy

S&P Dow Jones Indices

two

“A company for carrying on an undertaking of great advantage, but nobody to know what it is”

-Description of company marketed during the South Sea Bubble (1720)

Private companies, particularly those hailing from Silicon Valley and combining just the right mix of buzzwords, have captured both headlines and investor attention.  The media report breathlessly on the increasing herd of “unicorns” – private companies that have managed to achieve valuations of over a billion dollars – while a pursuing pack of venture capital and private equity funds competes to place ever higher valuations on their portfolio companies in advance of their initial public offering (IPO).

However, a post-IPO pop up in pricing is not guaranteed.  The additional price transparency that comes from a public listing can be challenging: earnings must be reported, sceptical market participants can short stocks and thereby act to deflate bubbles, and (perhaps most importantly) the existence of an actual stock price eliminates the ability of venture capital and private equity funds to assign arbitrary valuations to their holdings, at a time of their convenience.

Recently, there have been signs of trouble in tech paradise, with Uber and Lyft’s post-IPO struggles and WeWork’s “failure to launch” highlighting the potential challenge of transferring private valuations onto the public stage.  The S&P U.S. IPO and Spin-Off Index, which measures the performance of U.S. companies worth over $1 billion that have IPO’d or spun-off within the last five years, has underperformed the S&P 500® by 11% over the last 6 months.

There could be more hard times ahead.  According to Professor Jay Ritter at the University of Florida, last year, 81% of companies to IPO in the U.S. did so with negative 12-month trailing earnings on the day they went public. This was the highest such proportion since the tech bubble days of 2000, up from 76% in 2017 and 67% in 2016.

According to our analysis, this trend has continued in 2019.  80 percent of this year’s IPOs with data available reported negative earnings over the 12 months preceding their launch.  Had not WeWork and Endeavor pulled their IPOs in recent weeks, the figure would have been on track for the highest reading ever.

These trends may give investors pause regarding the stellar valuations currently held by pre- IPO companies, particularly those without a clear path to profitability.  The current environment also emphasizes the importance of benchmark construction for ‘market’ indices, some of which place constraints on the additions of newly-listed, or unprofitable companies, and some of which don’t.  Investors tracking the S&P Composite 1500® family of indices, which includes the S&P 500, the S&P MidCap 400® and the S&P SmallCap 600®, may be less exposed: each of these indices requires both a history of positive earnings, and a one year seasoning period (for new listings), before companies become eligible for inclusion.

Sometimes, requiring a demonstrated profit before investing in a company means missing out on the next “big thing”.  However, the problem with unicorns is that they are most often found in fairy tales.

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

S&P Risk Parity Indices: Positioning for Uncertainty

Contributor Image
Rupert Watts

Senior Director, Strategy Indices

S&P Dow Jones Indices

two

Uncertainty has been a common theme throughout 2019, and the third quarter proved no different. The quarter was dominated by uncertainties surrounding the U.S.-China trade talks as well as falling global growth forecasts. Demand for high-quality fixed income assets increased, pushing the yield on the 10-Year U.S. Treasury Bond down 34 bps. In spite of the mixed economic data and trade tensions, equities finished the quarter in positive territory, with the S&P 500® returning 1.7%.

As Exhibit 1 shows, the S&P Risk Parity Indices built upon the new highs set in Q2 2019 to post modest gains in Q3 2019.

Exhibit 2 shows the performance attribution for the S&P Risk Parity Index – 10% Volatility Target, where we can observe that the majority of the YTD performance came from equities and fixed income in the midst of contrasting sentiments across these two core asset classes.

Looking to the future, with many unpredictable variables at play—such as interest rates, bond yields, equity volatility, inflation, and more—what does the S&P Risk Parity Index Series have to offer?

The short answer is: a lot. These indices aim to generate stable returns across a range of economic environments, specifically growth and inflation. By allocating across three core asset classes—equities, fixed income (nominal bonds), and commodities—the indices strive to perform well or outperform traditional investments across rising and falling growth and inflation.

Across the growth dimension, equities and bonds are complementary. As growth rises or is better than expected, stocks tend to rise due to better earnings, whereas nominal bonds tend to perform less well. The opposite is true when growth falls or is weaker than expected.

Across the inflation dimension, equities and bonds are less complementary, as both are expected to perform well during periods of low or falling inflation, and less well during periods of rising inflation. Hence, commodities play an important role by offering inflation protection.

Exhibit 3 shows the average monthly risk-adjusted returns across asset classes during the four economic environments since 1973. The growth indicator uses the Chicago Fed National Activity Index (CFNAI), a monthly index designed to gauge overall economic activity (growth up if greater than 0; growth down if less than 0). The inflation indicator uses the US CPI Urban Consumers YoY NSA series (inflation up if higher than prior month; inflation down if lower than prior month).

Unsurprisingly, equities performed strongly during a growth up environment, and nominal bonds performed well during a growth down environment. With respect to inflation, commodities provided a natural hedge to equities and nominal bonds during rising inflation and vice versa. Thus, within each environment, one or more asset class historically served to offset any underperformance.

The foregoing begs the question: are the S&P Risk Parity Indices expected to outperform in every environment? The answer is no. The S&P Risk Parity Indices tend to underperform during strong bull markets. This could be expected given the higher equity allocation that traditional portfolios often have. Additionally, the indices tend to underperform during a rapidly rising rate environment. However, it is important to note that when rates rose gradually over time, risk parity historically performed fairly well.

It is hard to predict what the future has in store, but the S&P Risk Parity Indices appear to be well-positioned for whatever lies ahead in this uncertain landscape.

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

Factor Analysis of U.S. Small-Cap Benchmarks

Contributor Image
Phillip Brzenk

Senior Director, Strategy Indices

S&P Dow Jones Indices

two

We recently published the 10-year anniversary edition of the paper “A Tale of Two Small-Cap Benchmarks,” which gives insight into why the S&P SmallCap 600® outperformed the Russell 2000, historically.[1] Our latest paper also showed that, in the period from Dec. 31, 2002, to Dec. 31, 2018, profitable companies typically outperformed unprofitable companies in the U.S. small-cap market.[2] Given the S&P SmallCap 600 employs a profitability screen, this blog uses both returns-based and holdings-based factor analyses to gauge the actual impact compared with the Russell 2000.[3]

We begin with a returns-based regression analysis,[4] adding a quality factor to the standard Fama-French three-factor (market, size, and value) model. We use profitability as a proxy for quality given it is a key component in measuring quality. Exhibit 1 shows the regression results from the period between Dec. 31, 1993, and June 30, 2019.

Exhibit 1 shows that the two benchmarks had similar exposures to the standard three factors. However, there was a stark contrast in quality factor exposures: the S&P SmallCap 600 had a positive and statistically significant exposure to quality, while the Russell 2000’s near-zero exposure was statistically insignificant. This suggests that the S&P SmallCap 600 benefited by better capturing the quality factor returns, historically.

Next, we use a commercial risk model to see the active fundamental factor exposures for the S&P SmallCap 600 compared with the Russell 2000. This method could be considered a more‑robust process in measuring factor exposures since it looks at each benchmark’s holdings instead of relying on return regressions. Exhibit 2 shows the average active exposure of the profitability factor for the S&P SmallCap 600 relative to the Russell 2000 in each of the last 16 years. There is clearly a consistent, positive active exposure to the profitability factor for the S&P SmallCap 600, regardless of market environment.

Exhibit 3 gives a summary of average annual active exposures and factor returns of all factors in the model. The last column shows the impact—or excess return—attributable to each factor, calculated as the product of the active exposure and factor return.

Out of all factors in the model, the S&P SmallCap 600 had the highest tilt toward the profitability factor, and this positive tilt contributed to its outperformance over the Russell 2000; the compounded impact attributable to the profitability factor is approximately 0.71% on an average annualized basis.

As a result, the S&P SmallCap 600’s profitability requirement resulted in a positive quality tilt relative to the Russell 2000. This tilt played a material role in explaining the long-term outperformance of the S&P SmallCap 600.

For more information, check out our research paper “A Tale of Two Small-Cap Benchmarks: 10 Years Later.”

[1] Also see our previous blog, “Index Construction Matters in U.S. SmallCap,” by Aye Soe.

[2] See Exhibit 7 in A Tale of Two Small-Cap Benchmarks: 10 Years Later for more details.

[3] See Exhibit 3 in A Tale of Two Small-Cap Benchmarks: 10 Years Later for more details.

[4] See Exhibit 14 in A Tale of Two Small-Cap Benchmarks: 10 Years Later for more details.

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

Does Size Affect the Active versus Passive Score of Small-Cap Mutual Funds?

Contributor Image
Berlinda Liu

Director, Global Research & Design

S&P Dow Jones Indices

two

In my earlier blog, we explored the effect of size on active large-cap equity funds’ performance. We ranked all long-only active large-cap equity funds by their size at the beginning of the observation period and divided them into quartiles, with the first quartile being the largest and the fourth being the smallest. We found that, in general, the largest ones tended to lead by returns, volatilities, survival rates, and the ability to outperform the benchmark.

In this blog, we performed a similar analysis of the small-cap funds. Our study shows the diminished advantage of larger funds in this space. Small-cap funds of all quartiles underperformed the S&P SmallCap 600® across mid- and long-term investment horizons.

During the test period ending in March 2019, the S&P SmallCap 600 lagged three out of four quartiles of small-cap funds over the past year, but outperformed all quartiles across the mid- and long-term investment horizons (see Exhibit 1). Unlike the large-cap funds, the largest small-cap funds did not always generate higher annualized returns than their peers. In the past 15 years, annualized returns in the first, second, and third quartiles were quite similar.

Not surprisingly, the majority of small-cap funds in all quartiles underperformed the S&P SmallCap 600 over the mid- to long-term investment horizons. If we assume that all “dead” funds underperformed the benchmark, then more than 90% of each group underperformed the benchmark over the past 15 years, and the largest funds had the lowest underperformance percentage among the four groups. However, if we account only for funds that survived the testing periods, then the third quartile funds had the lowest percentage of underperformance compared with the S&P SmallCap 600 (see Exhibit 2).

Furthermore, the S&P SmallCap 600 generated similar or lower volatilities compared with active small-cap funds over all time periods analyzed (see Exhibit 3).

Interestingly, our analyses show that the larger funds had a significantly higher survival rate than their smaller peers, especially over longer horizons (see Exhibit 4). Only 41% of the third quartile funds that existed at the beginning of the 15-year study period survived the entire period, compared with a survival rate of 71% for the larger funds over the same period.

Our study shows that the relatively simple and transparent S&P SmallCap 600, a beta exposure to the U.S. small-cap space, outperformed the majority of small-cap funds (on a return and risk-adjusted basis), regardless of AUM over the long term.

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