Indexology^® Blog

Since the release of the Intergovernmental Panel on Climate Change (IPCC) report[1] in October 2018, there has been growing investor interest in 1.5^οC scenario-aligned portfolios. In May 2018, the EU announced its action plan for sustainable finance, which included proposals to create two new carbon transition benchmarks (EU Climate Transition [CTB] and Paris-aligned Benchmarks [PAB]). The EU appointed a technical expert group (TEG) to report on the minimum standards for new benchmarks. On Sept. 30, 2019,[2] the TEG released its final report on benchmarks and benchmark ESG disclosures. The report provides information regarding the preparation of the delegated acts by the European Commission, which will be published in draft form before the end of the year. What is the likely effect of the TEG’s proposals on indices?

Consistent tracking error over time is commonplace for ESG indices, due to their design. However, new EU proposals on climate benchmarks[2] make the CTB and PAB active risk dependent on the parent index’s ability to meet their 7% year-on-year decarbonization trajectory (which is the linear decarbonization required for a 1.5^οC scenario), due to absolute carbon intensity reductions rather than relative.[3] Therefore, tracking error will be driven by the parent index, which is outside of the control of CTB or PAB. This is not good or bad, in essence, but is a new paradigm for investors if they want to invest in CTB- or PAB-aligned products.

Exhibit 1 shows future PAB and CTB trajectories, as well as a range of possible trajectories from 7% decarbonization and 3% carbonization of the index (the first chart). Here it can be seen how much market trajectory divergence from a 1.5^οC scenario could affect the index’s future Weighted Average Carbon Intensity (WACI). The second chart in Exhibit 1 shows the potential future carbon intensity reduction required to align with the TEG’s proposals for the CTB and PAB.

If the parent index decarbonizes at 7%, the level proposed in the TEG report, both the CTB and PAB would keep their initial level of percentage reduction, at 30% and 50%, respectively. However, if the parent index does not decarbonize at such a rate, the carbon intensity reduction would increase over time.

Due to the high skew of 17 for companies’ carbon intensity, (see Exhibit 2) the carbon intensity reduction and resulting active share of the CTB and PAB do not have a linear relationship. Achieving the initial 30% or 50% reduction does not require a large active share, as heavily underweighting or excluding the most carbon intensive companies would drastically reduce the WACI. However, active share would increase exponentially as carbon intensity reduction requirements rise and other constraints are incorporated.

These carbon intensity reductions are the absolute minimum needed to meet the TEGs proposals for CTBs or PABs. Therefore, reduction targets will likely have to be larger than the required reduction to ensure the PAB and CTB have sufficient leeway when weight drift affects the index’s WACI.[4]

In recent years, the S&P Global LargeMidCap’s WACI has trended downward (see Exhibit 3), however, there have been fluctuations.[5] Due to the high concentration in carbon intensity in a few companies, their performance, and therefore weight in market-cap-weighted indices, is a large driver of an index’s WACI. Therefore, if the most carbon-intensive companies outperform, the WACI will increase significantly.

Overall, there are various carbon intensity trajectories market-cap-weighted indices can take, which would affect the level of active share required of indices to meet the TEG’s propsals for CTBs and PABs. As the proposed requirements of carbon reduction from the parent index increase, the active risk taken could rise expotentially due to the high positive skew in the distribution of corporates carbon intensity. This absolute emission target, as opposed to a relative emission reduction, is a new paradigm for index design.

[1] IPCC, 2018: Global warming of 1.5°C. An IPCC Special Report on the impacts of global warming of 1.5°C above pre-industrial levels and related global greenhouse gas emissions pathways, in the context of strengthening the global response to the threat of climate change, sustainable development, and efforts to eradicate poverty [V. Masson-Delmotte, P. Zhai, H. O. Pörtner, D. Roberts, J. Skea, P.R. Shukla, A. Pirani, W. Moufouma-Okia, C. Péan, R. Pidcock, S. Connors, J. B. R. Matthews, Y. Chen, X. Zhou, M. I. Gomis, E. Lonnoy, T. Maycock, M. Tignor, T. Waterfield (eds.)]. In Press.

[2] The EU Technical Expert Group on Sustainable Finance. (2019). TEG Final Report on Climate Benchmarks and Benchmarks’ ESG Disclosures. https://ec.europa.eu/info/sites/info/files/business_economy_euro/banking_and_finance/documents/190930-sustainable-finance-teg-final-report-climate-benchmarks-and-disclosures_en.pdf.

[3] The current norm for indices is to seek a relative change from the benchmark. However, under the proposals of the TEG, the index provider shall set their 30 % (for the CTB) and 50% (for the PAB) reduction anchor, then set the trajectory line for the decarbonization of the CTB and PAB. As a result, the CTB and PAB make an absolute level of reduction, rather than a relative one.

[4] The WACI has to be calculated using average weights over the period, according to the TEG’s proposals.

[5] The S&P Global LargeMidCap’s carbon intensity has not been adjusted for inflation as the proposed in the TEG’s report. Therefore, when adjusted for inflation, the slope would have less of a negative trajectory.

The broad commodities market rose modestly in October. The S&P GSCI was up 1.2% for the month and up 10.0% YTD. The Dow Jones Commodity Index (DJCI) was up 1.9% in October and up 6.7% YTD. Gains were spread surprisingly evenly across the individual commodity markets

As has been the case all year, the star performer in the petroleum complex in October was gasoline; the S&P GSCI Gasoline was up 5.2% for the month, driven by unscheduled refinery outages in the U.S. as opposed to particularly strong consumer demand. Despite a brief pick up in prices in October (S&P GSCI Natural Gas up 3.6%), the natural gas market remains mired in oversupply, with production growth continuing to outpace domestic consumption and export opportunities. U.S. natural gas stocks have pushed above the five-year average despite lower prices and a sharp drop in the number of rigs drilling for gas.

As the annual LME Week in London came to an end, the majority of metals across the industrial complex ended higher in October on the back of trade war resolution hopes and labor strikes in Chile. The two exceptions were S&P GSCI Iron Ore and the S&P GSCI Nickel, which were down 5.9% and 2.1%, respectively, but both were still up near 60% YTD. Nickel mines in Indonesia agreed on Oct. 28, 2019, to stop nickel ore exports immediately, pulling forward the already expedited January 2020 deadline. After nickel prices moved higher by 24% in August, a period of consolidation is understandable.

Palladium outperformed in the precious metals space in October on the back of a glaring supply shortfall. The platinum to palladium ratio is at the lowest in the last 25 years, reflecting the strength of the palladium market; the S&P GSCI Palladium was up a solid 6.7% in October and up 50.4% YTD. The S&P GSCI Gold continued its slow march higher, adding 3.0% on the month and up 17.6% YTD, driven higher by catalysts such as the U.S. Fed’s third rate cut and the Diwali festival in India.

The agriculture complex continues to wait patiently for positive news on the U.S.-China trade war front. The S&P GSCI Agriculture was up 1.4% in October. China has been back in the U.S. soybean market, although to a lesser degree than before the trade war, but the two countries are still finalizing a “Phase 1” trade pact that many expect will boost U.S. agriculture exports to China, particularly soybeans. The S&P GSCI Cotton ended the month up 6.1% on concern regarding the condition of the U.S. crop due to poor weather during harvest. The newly launched S&P GSCI Skim Milk Powder also ended the month in positive territory, up 5.1%, continuing to benefit from strong global milk powder demand.

It was a mixed bag in the livestock sector in October; S&P GSCI Lean Hogs was down 9.0% while S&P GSCI Live Cattle rose 6.4%. Volatility in the lean hog market continues, as market participants flip between focusing on the devastating supply cuts caused by African swine flu in China and the export-depleting drag of the ongoing U.S.-China trade war.

The S&P/BMV Index Series combines the local market expertise of the Mexican Stock Exchange (the BMV) with the resources and reach of one of the most prominent independent global index providers, S&P Dow Jones Indices (S&P DJI). This productive collaboration officially began in May 2015 and adheres to international standards. The relationship also provides the opportunity to create new indices across different asset classes in the Mexican market.

The S&P/BMV Indices cover:

• Equities: Mexico’s flagship index is the S&P/BMV IPC, with additional indices spanning across sectors, strategies, and sizes.
• Fixed Income: Indices in this category range from tracking sovereign bonds to corporate bonds, offering different ratings based on maturities, coupon types, and currencies, as well as nominal and inflation-linked securities.
• Volatility: The S&P/BMV IPC VIX is designed to measure the implied 90-day volatility of the Mexican stock market.
• Multi-Asset: The S&P/BMV Mexico Target Risk Index Series comprises strategy indices that represent stock and bond allocations across a risk spectrum spanning from conservative to aggressive.

We are constantly designing new indices to serve as innovative and practical tools for local and global investors. To ensure the indices are replicable and investable, we incorporate feedback from market participants. Over the past four years, we have launched a complete suite of single-factor indices. More recently, we debuted the first multi-factor strategy, the S&P/BMV IPC Quality, Value & Growth Index. These indices could serve as the basis for financial products like ETFs, among others, to be incorporated into portfolio strategies.

In our commitment to ESG, S&P DJI has collaborated with the Consejo Consultivo de Finanzas Verdes (CCFV). This council aims to promote the financing of green projects and generate common sustainability standards for market practices in Mexico. Together, S&P DJI and the BMV selected SAM, a highly reputable Swiss investment specialist focused exclusively on sustainable investing, as the official score provider for the development of ESG-based S&P/BMV Indices.

In the ongoing global debate about active versus passive investment, S&P Dow Jones Indices has played a major role by publishing the SPIVA^® and Persistence Scorecards for Latin America. These reports include historical performance measurements of actively managed equity mutual funds in Mexico compared with the S&P/BMV IPC[1] over different time horizons.

S&P Dow Jones Indices congratulates the BMV on its 125th anniversary. Our commitment to Mexico and the BMV is to continue working on new, innovative indices for the country’s markets.

For further information, visit our website: https://spdji.com/regional-exposure/americas/mexico.

[1] The reports measure the S&P/BMV IPC’s total return version, the S&P/BMV IRT.

Amid the turbulent markets of 2019, the S&P Economic Cycle Factor Rotator Index has been holding steady. The index rotates its allocation between four indices benchmarked to factors—momentum, value, quality, and low volatility—seeking to pick the relevant factor for each phase of the business cycle. The index uses a signal that is based off the Chicago Fed National Activity Index, an economic growth indicator for the U.S. In 2019 alone, the index was allocated to each of the four factors, signaling that the business cycle had some unpredictability, with almost all micro cycles covering a slowdown, expansion, contraction, and recovery.

Historically, the index has regularly cycled through each of the factors in order to adapt to changing market conditions and allocate to the appropriate factor (see Exhibit 1).[1] The most recent allocation switch occurred in June, when the index allocation changed from low volatility to value, indicating that the economy shifted from a period of contraction to one of recovery. The fact that the index remained allocated to value even after rate cuts this year in July and September tells us that this strategy works to guard against significant movements in the market. Despite the market-wide sell-off at the end of 2018, the index has recovered most of the lost value throughout 2019.

In Exhibit 2, we see that, with the exception of last year, the S&P Economic Cycle Factor Rotator Index has not always outperformed its subcomponents. However, by allocating to the different indices, the index maintains a lower risk level while still having the ability to participate in an upward-trending market. As a result, the index achieved higher risk-adjusted returns from September 2009 to September 2019 relative to its sub-components (see Exhibit 3). When we look at the index’s one-year returns, we see that the index and all of its subcomponents had negative returns; value, buyback, low volatility, and momentum had returns of -16.45%, -13.43%, -12.28%, and -2.65%, respectively. It’s evident that the rotation aspect of the index helped protect the index against larger losses, since the S&P Economic Cycle Factor Rotator Index outperformed all of its subcomponents with a return of -2.51% in 2018. Since the index was mostly allocated between buyback and momentum in 2018, we know that the index returns were mainly driven by its momentum component.

By design, the index has a 6% risk control mechanism built in that helps it maintain a constant level of volatility, which in turn enables it to participate in the upside and offer downside protection relative to the S&P 500 Daily Risk Control 5% Index. As seen in Exhibit 4, when compared with the S&P 500 Daily Risk Control 5% Index, we see that the index captured 116% of the upside and 61% of the downside. The capture ratio of 190% shows us that the up-market performance more than compensated for the down-market performance, and that the index outperformed the market overall.

The S&P Economic Cycle Factor Rotator Index has shown that it is effective for adapting to changing market conditions with its ability to allocate to different indices depending on phases of the business cycle. Over the studied period, it not only generated higher returns with lower risk, but also captured more upside and less downside in various market conditions.

[1]   The buyback allocation utilizes the S&P Buyback FCF Index, the dividend index allocation utilizes the S&P 500 Low Volatility High Dividend Index, the value index allocation utilizes the S&P 500 Pure Value, and the momentum strategy utilizes the S&P Momentum United States LargeMidCap.

Yesterday marked 25 years since the launch of the S&P SmallCap 600.  Since then, the small-cap equity benchmark delivered an annualized total return of nearly 11% and has become the basis for many investment strategies; around USD 73 billion was indexed to the S&P SmallCap 600 as of the end of 2018.  And if we assume that these indexed assets would have otherwise been given to active funds, the rising adoption of the S&P SmallCap 600 helped to save around USD 5 billion in fees between 1996 and 2018.

One of the principal reasons for the growing popularity and awareness of the S&P SmallCap 600 has been its historical performance.  Index construction matters in U.S. small-caps: the S&P 600’s profitability criterion gives it a quality bias, which helped it to consistently outperform other small cap indices such as the Russell 2000 and made it a harder benchmark to outperform for active managers.

More recently, for those seeking to take shelter from the trade winds buffeting the blue-chip, internationally diversified names leading the S&P 500, small-cap stocks can offer a safe harbor, or simply purer exposure to the U.S. economy.  Smaller stocks typically have a higher proportion of their revenues generated in home markets, and the S&P SmallCap 600 has a strong domestic bias compared to the S&P 500.  The performance of the small-cap index over the last 12 months illustrates its close connections to the U.S. economic outlook.

After concerns over U.S. economic growth and future Fed policy weighed on the S&P SmallCap 600 towards the end of 2018, higher domestic revenue exposure provided a degree of insulation from the tariffs, which, in turn, helped the index to post its best ever start to the year (+15.45% through the end of February). The index has since been tested by periodic bouts of uncertainty centering around the health of the U.S. economy, comments by Jerome Powell, and actions by the Federal Reserve.

Since it launched on October 28, 1994, the S&P SmallCap 600 has become a popular way to access the small-cap equity space.  Its outperformance over other small cap indices is a testament to the fact that index construction matters in small cap equities.  Here’s to another 25 years!