Indexology^® Blog

Despite still ending the quarter higher, Q3 2019 was relatively subdued across asset classes when compared to the stellar performance we saw in equities in Q1 and Treasuries and gold in Q2. Exhibit 1 shows that the gains captured in Q1 and Q2 continued to compound in Q3, with the YTD performance of the S&P MARC 5% (ER) reaching 11.2%. As of Q3’s end, all components of the S&P MARC 5% ended in positive territory for each of the three quarters of 2019.

Looking at the index allocations from the beginning of Q3 2018 to the end of Q3 2019 (see Exhibit 2) we see that, while the mix of assets has changed significantly throughout this time, with equities taking a less prominent role due to the volatility seen at year-end 2018, the index continued to be over 100% allocated across the various asset classes at least 95% of the time. Despite Q4 2018’s volatility, the index only dropped below 100% on 15 days over the past year, keeping the strategy allocated to its underlying asset classes and not cash.

When looking at the relative performance of the S&P MARC 5% (ER) components versus the S&P MARC 5% (ER) itself, one can see that for the first half of the year, the gold and fixed income components actually lagged in performance. This changed toward the end of Q2 through mid-Q3, when gold also joined equities in outperforming the S&P MARC 5% (ER) on a relative return basis. The strength of the components allowed the S&P MARC 5% to start Q4 with a strong YTD performance, while still capturing the diversification built into the index.

During the 64 days in Q3 2019, we can see that for any of the rolling 252-day periods, the return of the S&P MARC 5% (ER) would have been positive despite the inconsistency of returns in most of its components. It’s also worth noting that across this period of time, the lowest rolling 252-day return for the S&P MARC 5% (ER) was 8.6% and the highest return was 13.4%—with an average return of 11.4%.

It is a truth universally acknowledged that liquidity is critical to market health; typically when liquidity falls, volatility rises.  The Financial Times recently cited claims that the increased use of passive investment vehicles had caused trading volumes in individual S&P 500 constituents to decline.  Should we be alarmed?

In reality, the notion that single-stock traders only add liquidity, while passive vehicles only diminish it, is wrong.  There are a great many active users of “passive” products, and any market-wide conclusions about liquidity require analysis not only of single stocks, but also of the ETFs and futures that track them.  A wider perspective is required because the volume of trading in ETFs, futures, and other index-based exchange-traded products is substantial.  Our research shows that there was an equivalent of around $127 trillion traded in products tracking the S&P 500 over the 12 months ending June 2019, while the implied average holding period across all S&P DJI index-linked exchanged traded products included in the report was 11 days.

To offer just one example that might broaden our perspective, consider how volumes in sector and industry-based products have grown over the past few years.  The assets, open interest, and trading volume in futures and ETFs tracking S&P DJI’s U.S. based sector and industry products has more than doubled.

In part, this may be a simple reflection of the recently increasing importance of sectoral drivers to stocks in the S&P 500.   At any rate, sectors have a long-term importance to stock returns.  Around half of all the daily variations in S&P 500 single stock returns over the past 15 years may be attributed to risks shared with their sectoral peers.

Because of their current liquidity and importance to returns, sector products can be, and often are, used to make active bets in place of individual stocks.  Individual stock volumes tell only part of the story, as investors may be choosing to use different vehicles to express their views.   An active manager who over- or under-weights a sector makes no less a contribution to price discovery and market efficiency than a manager who over- or under-weights the sector’s components.    Individual securities may currently be the road less traveled, but markets can arrive at accurate valuations from a different road.

On Oct. 21, 2019, S&P Dow Jones Indices (S&P DJI) launched the S&P GSCI Skim Milk Powder, an expansion of the single-commodity series offering of indices based on the S&P GSCI and the first index of its kind in the market. The S&P GSCI Skim Milk Powder is designed to provide investors with a reliable and publicly available investment performance benchmark for skim milk powder (SMP).

The S&P GSCI Skim Milk Powder is based on the NZX SMP futures contract, and it represents the first Oceania-based single-commodity index for the S&P GSCI index series.

Until now, dairy has been an inaccessible commodity for many market participants. The S&P GSCI Skim Milk Powder seeks to offer access to the return stream of a unique asset that is uncorrelated to major commodities such as gold but, at the same time, has a strong relationship to the New Zealand dollar and the New Zealand equity market.

There may also be opportunities for participants in the physical dairy market to utilize financial products based on the S&P GSCI Skim Milk Powder in conjunction with other risk management instruments. Broadening the financial instruments available to hedgers in the global dairy market is an important goal of the S&P GSCI Skim Milk Powder.

The S&P GSCI Skim Milk Powder joins the following two additional S&P GSCI dairy commodity indices that were launched by S&P DJI earlier this year based on CME futures contracts by the same name.

1. The S&P GSCI Nonfat Dry Milk, which is designed to provide investors with a reliable and publicly available benchmark for investment performance in the dry milk market.
2. The S&P GSCI Class III Milk, which seeks to provide investors with a reliable and publicly available benchmark for investment performance in the milk market.

The Global Dairy Market in Perspective

According to the International Dairy Federation, the consumption of dairy products is expected to increase by 25% between 2015 and 2024. While SMP is only a relatively small proportion of global dairy consumption, it is a large proportion of the global dairy trade. The dairy export market is dominated by milk powder, with approximately 3.9 million metric tons of SMP and whole milk powder traded annually.

Importance of Dairy to the New Zealand Economy

Dairy represents the largest export industry in New Zealand, and the dairy sector contributes NZD 7.8 billion (3.5%) to New Zealand’s total GDP. Export revenue from dairy farming was NZD 15.1 billion in 2017-2018, equivalent to 28% of the total value of New Zealand’s merchandise exports. This is more than two times the meat sector, three times the wood sector, and seven times the wine sector. New Zealand is the third-largest SMP exporter in the world after the EU and the U.S. China is most important destination for New Zealand’s dairy product exports.

Does the S&P 500® receive a premium over the S&P 500 ESG Index? Absent a premium from the S&P 500, investors could have their cake and eat it too with the S&P 500 ESG Index: similar or better performance, along with the benefits of ESG.

Academic literature suggests no sin stock premium over their non-sin counterparts. Sin stocks are usually defined by their product involvement (e.g., tobacco, controversial weapons, etc.). “The Price of Sin”[1] explored apparent outperformance of sin stocks, citing theories of neglected stocks and segmented markets. When adding sector controls to factors while ensuring the sin stock indices assessed are market-cap weighted[2] and evolving asset pricing models to include quality and low volatility factors,[3] a lack of sin premia was observed.

While the S&P 500 ESG Index does exclude some sin stocks, it also takes a more holistic view of ESG and removes the worst ESG companies, as measured by the S&P DJI ESG Scores.[4] Exhibit 1 displays the selection process for the S&P ESG Index Series.

The S&P 500 ESG Index is designed in alignment with the S&P 500’s risk/return profile, while removing the worst ESG performers. The S&P 500 ESG Index seeks to provide greater exposure to companies that, for example:

• Limit scope 3 GHG emissions and set targets for reduction;
• Actively monitor diversity-related issues;
• Have at least 50% female management representation
• Include performance and reporting on their ESG materiality analysis; and
• Tie executive compensation to material ESG issues.

Exhibit 2 shows the excess return over the risk-free rate for the S&P 500 ESG Index and the S&P 500, and it can be observed that the excess returns are similar. Furthermore, the tracking error over this period was 0.93% (which was even lower over the past five years, at 0.74%[5]). The annualized volatility of the S&P 500 ESG Index was slightly lower than the S&P 500, at 14.63% and 14.86%, respectively. The annualized return was 0.02% higher for the S&P 500 ESG Index than the S&P 500.

Following Blitz and Fabozzi’s approach,[6] the Capital Asset Pricing Model and its derivatives[7], which include factors assessing relative size, value, momentum, low volatility, and quality[8]. The S&P 500 excess return was used as the market risk premium to assess alpha (α) of the S&P 500 ESG Index.

For each model implemented, there is insignificant alpha present (see Exhibit 3), thus no significant out- or underperformance of the S&P 500 ESG Index compared with the S&P 500 during this period.

As the returns of the S&P 500 ESG Index are so close to those of the S&P 500, plus the opportunity to receive all the ESG benefits, why not choose the S&P 500 ESG Index over its market-cap-weighted parent?

[1]   Hong, H., & Kacperczyk, M. (2009). The Price of Sin: The Effects of Social Norms on Markets. Journal of Financial Economics, 15-36.

[2]   Adamsson, H., & Hoepner, A. (2015). The ‘Price of Sin’ Aversion: Ivory Tower Illusion or Real Investable Alpha?

[3]   Blitz, D., & Fabozzi, F. (2017). Sin Stocks Revisited: Resolving the Sin Stock Anomaly. Journal of Portfolio Management, 82-94.

[4]   Please see the S&P 500 ESG Index methodology for more information.

[5] Source: S&P Dow Jones Indices LLC. Performance data from May 31, 2014, to May 31, 2019.

[6]   Blitz, D., & Fabozzi, F. (2017). Sin Stocks Revisited: Resolving The Sin Stock Anomaly. Journal of Portfolio Management, 82-94.

[7]   French, K. F. (1992). The cross-section of expected stock returns. Journal of Finance, 427-465; French, K., & Fama, E. (2015). A Five-Factor Asset Pricing Model. Journal of Financial Economics, 1-22; Carhart, M. (1997). On Persistence in Mutual Fund Performance. The Journal of Finance, 57-82; Frazzini, A., & Pedersen, L. (2013). Betting Against Beta. Journal of Financial Economics, 1-25.

[8]   These models have been run using data from May 1, 2010, the start of the S&P 500 ESG Index’s back-tested history, through July 31, 2019, the most recent date for which the factor returns are available, using daily returns. The index levels are sourced from S&P Dow Jones Indices LLC, while the factor returns are sourced from Kenneth French’s website (French, K. [September 2019]. Current Research Returns. (French K. , Current Research Returns, 2019) and AQR (AQR. (2019, September). Betting Against Beta: Equity Factors, Daily. https://www.aqr.com/Insights/Datasets/Betting-Against-Beta-Equity-Factors-Daily)

In India, the festival of lights known as Diwali brings with it a seasonal uptick in gold imports. A feature of this renowned festival involves the exchange of gifts among friends, families, and colleagues. The most popular gift to give during the festival is gold. The propitious sentiment toward the precious metal makes it a perfect gift during this time. Jewelry is also prominently worn by families throughout the five-day festival, making gold an integral piece of this ancient tradition.

Gold tends to shine bright during the second half of the year as demand picks up. It is estimated that Diwali accounts for approximately one-fifth of annual gold purchases in India—more than any other time of the year. Jewelers and gold coin dealers in India frequently see a spike of 20%-30% in sales leading up to the festival. India is the second-largest consumer of gold after China, although they are close in size, with each accounting for approximately 30% of net global imports of the yellow metal in 2017. Gold is the second-largest import in India after crude oil, illustrating how important the country is to the global gold market and likewise how important it is for Indian consumers to appreciate the global supply/demand dynamics of gold.

 The consumption of gold during the Diwali festival and peak wedding season running from August to December is unlike anywhere else in the world. This year, Diwali demand will compete directly with a favorable cyclical environment for gold investment. Gold has been one of the best-performing commodities this year. As of Sept. 30, 2019, the S&P GSCI Gold was up 14.21% YTD and on par with the S&P 500®, which was up 18.74% YTD. Historically, the metal tends to perform well in times of global economic uncertainty, low interest rate regimes, and periods of U.S. dollar weakness. In an environment in which negative-yielding government debt is only increasing, investors have shown their willingness to allocate a larger portion of their portfolio to gold, for which there is no yield that could turn negative. Data from the World Gold Council suggests that investor and central government demand for gold has grown at a faster pace than jewelry demand through the first six months of this year.

The Indian gold market has shown its resilience even when import taxes are raised, as they were in July of this year, from 10% to 12%. Gold prices simply marched higher, as can be seen by Exhibit 4. There was a similar outperformance in 2013, the last time India raised import tax duties. What is interesting about 2013 is the S&P GSCI Gold saw a drastic move lower on the year, down almost 30%, while local gold prices in India moved less than half that amount. A tax increase can usually be seen as a headwind for demand, but it was overcome by the sheer force of gold buying in India. This year, local gold prices in India have outperformed the S&P GSCI Gold, albeit not as pronounced as in 2013. Regardless, the cultural significance of gold in India provides a firm base for demand and prices.