Indexology^® Blog

The critics of passive investing are nothing if not creative.  One of their objections to the growth of index funds stems from the putative problem of “common ownership.”  The argument is that index funds’ ownership of many of the competitors in most industries encourages or facilitates collusive behavior.  “[T]he fear is that by owning chunks of many companies in a sector…investors are influencing them to act in ways that maximize gains for all. That is opposed to pushing individual companies to compete more vigorously with rivals and undercut one another on price.”

Many of the fronts in the counterattack against indexing are manned largely by active investment managers; this one, in contrast, seems to be mainly the province of academics, and especially of law professors, some of whom think that index fund ownership of much of corporate America violates anti-trust law.  Probably the most often-cited example of the putative common ownership effect is an academic claim that U.S. airline ticket prices are “10% to 12% higher because of common ownership.”  No one, interestingly enough, claims that index funds explicitly encourage corporate managements to fix prices; rather, index managers supposedly don’t encourage vigorous competition.  “Doing nothing, that is, not pushing portfolio firms to compete aggressively against each other” supposedly produces anti-competitive results because corporate managements know that their shareholders are also owners of their competitors.  “Softer competition” is simply a result of the nature of every corporation’s shareholder registry.

It’s not hard to understand why professors like this argument so much: it’s clever and reflects a basic understanding of industrial structure.  Monopolies are more profitable than competitive markets.  However, making the argument that index funds are the likely driver of monopolistic behavior requires us to believe in two additional propositions:

1. The sum of the profits of competing firms will be higher if they share a monopoly than if they compete against one another aggressively.
2. Some shareholders, including (but not limited to) index funds, own shares in more than one competitor, and may therefore be happy with their proportional share in a monopoly.

The problem is that proposition 1 does not depend on proposition 2.  Having a share of a monopoly may be more profitable than competing actively, for both shareholders and firms, even if there is no overlap in ownership.  If there are competitive issues in some industries, index funds can’t be fairly blamed for producing them.

The broad commodities were tepid in November. The S&P GSCI was flat for the month and up 9.9% YTD. The Dow Jones Commodity Index (DJCI) was down 2.1% in November and up 4.5% YTD. Gains were driven by the energy complex, while both precious metals and industrial metals detracted from headline performance.

The S&P GSCI Petroleum was up 2.0% in November. Oil prices were poised to end the month near two-month highs on expectations of an extension of OPEC+ production cuts, but on the last trading day of the month prices fell by over 4% due to fresh concerns over U.S.-China trade talks and a record high U.S. crude output of 12.5mm barrels per day. OPEC and Russia are likely to extend existing production cuts by another three months to mid-2020 when they meet in early December. In the physical oil market, traders are paying near-record premiums for sweeter crude barrels, as new marine fuel regulations from the start of 2020 have encouraged refiners to use crude oil grades that produce less high-sulphur fuel oil.

The S&P GSCI Nickel was in freefall in November, down 18.1%, with the largest move by far within the industrial metals space. This was due to the market focusing attention on current subpar demand, even with Indonesia cutting back exports. Prices for stainless steel, of which nickel is a component, have continued to decline due to record inventories. With a technical drop in support of its 200-day moving average and market participants’ bullish positions exited, the environment was ripe for a big move lower. In spite of these conditions, the S&P GSCI Nickel was still up 29.5% YTD and was one of the better-performing commodities overall. The S&P GSCI Lead and the S&P GSCI Zinc fell about 10% and 8% respectively, while the S&P GSCI Iron Ore rose 7.71% after falling 5.9% the prior month.

The S&P GSCI Gold lost some of its luster in November, down 3.1% on the back of an overall better risk sentiment, with equity markets continuing to post new all-time highs and VIX® near multi-month lows. However, gold’s loss was palladium’s gain. The S&P GSCI Palladium continued to add to its impressive YTD performance, reaching another new high on the last day of the month to close November up 3.4% and up 55.55% YTD.

The S&P GSCI Agriculture was down marginally in November. As harvest in the U.S. comes to an end, both the corn and soybean markets have continued to be weighed down by the protracted U.S.-China trade talks and plentiful domestic supplies. Improving weather for planting in Brazil and Argentina also added pressure to the markets. The S&P GSCI Coffee ended the month up 13.4%; Arabica coffee supplies have  tightened from recent record levels, with a global deficit now forecast for the 2019-2020 season, an off-year for top producer Brazil’s biennial crop cycle. Certified stocks on the Intercontinental Exchange (ICE) also fell to their lowest level in nearly 18 months.

It was another mixed bag for the livestock sector in November; the S&P GSCI Lean Hogs was down 11.0%, while the S&P GSCI Live Cattle rose 2.8%. Despite the fact that the U.S. sold more pork this year to international buyers than ever before, the S&P GSCI Lean Hogs was down 22.9% YTD, reflecting a significant increase in pork supply. U.S. pork production is on a record pace for 2019.

The Wall Street Journal recently quoted several active managers who claim that “conditions for stock picking are improving”. Their rationale is that declining correlations among stocks in the S&P 500 have made it easier for active managers to select stocks based on fundamental analysis.

We have heard this argument before, most notably in 2014 when, as Exhibit 1 demonstrates, correlations had fallen substantially from their financial crisis peak. But 2014 was also a year of record underperformance by active managers, as our SPIVA scorecards demonstrate. As we have argued previously, this is because dispersion, not correlation is the appropriate metric with which to measure the prospective success of stock pickers.

Correlation is a vital tool in analyzing portfolio diversification, but it is dispersion, or cross-sectional portfolio volatility, that offers a more meaningful way to identify opportunities for active management.  Exhibit 2 offers a simple illustration that demonstrates this point:

Compare stock pairs A and B versus C and D. Both pairs have an average return of 6.85%, but it’s obvious that an active manager who can choose between C and D can add more value than her competitor who chooses between A and B. And yet – the correlation of A and B is negative, while the correlation of C and D is 1.0. Dispersion, not correlation, determines the value added potential of active managers.

Factor investing in Asia has grown at a rapid pace, with smart beta passive AUM growing at a 42% compound annual growth rate over the past five years, albeit from a relatively lower base.[1] With increasing awareness of climate change and related risks, investors may look to integrate carbon screening into their factor portfolios.

In our research paper, Integrating Low-Carbon and Factor Strategies in Asia, we constructed pure factor portfolios (momentum, value, quality, and low volatility) and studied the impact of carbon screening on these portfolios in seven Asian markets—Australia, China, Hong Kong, India, Japan, South Korea, and Taiwan. The pure factor portfolios were constructed by selecting the top quintile of stocks by factor scores from each market from their respective base universe. The carbon-efficient factor portfolios included the same number of stocks as in their respective pure factor portfolios, but were selected from the carbon-screened universe, from which the 33% of stocks with the highest carbon intensity scores were removed. The pure factor and carbon-efficient portfolios were unconstrained by sectors and were equally weighted. The carbon-efficient screening affected the performance and carbon intensity of each factor portfolio differently (see Exhibit 1).

Overall, the carbon screening resulted in higher carbon intensity reductions to the low volatility and value factors than to the quality and momentum factors across Asian markets. Carbon-efficient screening also improved risk-adjusted returns for the quality, value, and momentum portfolios. In contrast, low volatility factor performance was adversely affected by the carbon-efficient screening.

Additionally, carbon screening resulted in different sector exposures when compared with the pure factor portfolios. For example, compared with the pure quality portfolios, the carbon-screened quality portfolios tended to overweight Financials and Information Technology and underweight Materials and Consumer Staples (except in Australia). On the other hand, compared with the pure value portfolios, the carbon-screened value portfolios tended to overweight Financials and Consumer Discretionary and underweight Materials and Energy. For the momentum and low volatility factors, carbon-efficient factor portfolios tended to overweight Financials and Consumer Discretionary and underweight Materials with respect to pure factor portfolios.

Exhibit 2 shows the active factor exposures (in terms of the number of standard deviations) of the carbon-efficient factor portfolios versus their respective pure factor portfolios in Japan. In most cases, the impact of carbon-efficient screening was modest on the targeted factor exposures. Similar observations were made in other Asian markets. We can conclude from these results that carbon-efficient screening did not result in the loss of targeted active factor exposure.

[1]   Banerjee, Alka, “ETFs and the Factor-Based Investing Landscape,” Forum Views: One World One BBF, Vol. 8, Issue 1, pp. 154-156, April 2019.

As green investing becomes ever more mainstream, there is greater scrutiny of the myriad “environmentally friendly” investment products that have emerged. Several green-labeled benchmarks have been criticized for including oil and gas stocks, for instance, sparking some controversy within the sustainable investment community. However, while efforts to make financial products more transparent are laudable, not all arguments favoring divestment depict a complete and accurate picture. More often than not, divestment is more principled than practical when it comes to achieving the low-carbon transition.

As an independent index provider, S&P Dow Jones Indices has the responsibility of being transparent with its methodologies and marketing. Educating stakeholders, including investors, policymakers, and the media, is key to bridging expectations with the financial jargon that often plagues lengthy methodology documents. This is especially relevant in climate finance, for which the threat of “greenwashing” looms large. But divesting from fossil fuels is just one approach—and not all “green” products necessarily ought to do so. Indeed, the climate-conscious investor has two options.

1. Divest: To align one’s investments with one’s values and send a reputation-hitting signal that potentially reduces a firm or industry’s license to operate.

2. Engage: To retain a seat at the table to influence company behavior, drive industry change, or advance a particular cause.

The divestment movement does not argue that divesting will necessarily decrease a company’s value—it is primarily an expression of values for the principled investor. Engagement, on the other hand, is a tool for effecting a particular change. That said, more than 1,000 institutional investors with USD 11 trillion in assets are divesting from fossil fuels,[1] with some citing motives such as the avoidance of stranded-asset risk. Many banks and insurers have also committed to neither finance nor underwrite fossil fuel projects, inevitably slowing the industry’s expansion. However, divestment will not likely move a company’s stock price so long as there continue to be many investors who do not share the same moral virtues.[2] Ultimately, both approaches are valid, depending on the objectives of the individual investor.

This dichotomy is well understood in the active space, given shareholder advocacy, but there are parallels with passive investing too. If engagement is any strategy that influences company behavior, then benchmarks can also be an effective tool for engagement. Take the S&P Carbon Efficient Index Series, for instance (see Exhibit 1).

By excluding any of the world’s 100 biggest carbon emitters who don’t disclose, and retaining reweighted exposure to all other companies—including fossil fuel stocks—the S&P Carbon Efficient Index Series reduces the carbon footprint by as much as 20%-45%, while uniquely encouraging:

1. Greater transparency, by rewarding companies that disclose emissions with a 10% higher index weight; and critically,

2. The transition of business models toward low-carbon alternatives over the long term, as companies seek to improve their standing in the index.

Our novel methodology sorts companies into deciles by carbon intensity within GICS^® industry groups and reweights them accordingly. However, since some industries are inherently more greenhouse gas-emitting than others, we consider the spread of industry group emissions and adjust weights by a greater or lesser extent, depending on how much a company can feasibly improve given available technologies (see Exhibit 2).[3] Companies are thereby incentivized to disclose and decarbonize to boost their overall standing. So although fossil fuel-free strategies tick certain boxes, they typically achieve less in terms of decarbonizing prowess.

Thus, so long as a methodology is transparent with its aims, it may make sense to include fossil fuel stocks in green indices. Naysayers may want to look closer at whether a strategy intends to divest or engage, because while both are green, only one is actually “greening.”

[1]   Source: https://www.ft.com/content/4dec2ce0-d0fc-11e9-99a4-b5ded7a7fe3f

[2]   See https://www.newyorker.com/business/currency/does-divestment-work for an explanation for why divestment requires a critical mass of adopters to have any real impact on stock prices.

[3]   Click here to learn more about the S&P Carbon Efficient Index Series and Industry Group Impact Factor Weights.