Indexology^® Blog

Rarely do we see all segments of the market go up in unison, but 2019 saw broad-based gains across stocks, bonds, and commodities. In fact, not a single sovereign bond index we track ended in the red. Considering 42 central banks cut policy rates in 2019, this may have been expected, but we would have to go back to 2004 for the last time not a single S&P DJI sovereign bond index ended the year in the red.

Seeing green in 2019 wasn’t just for government bonds, as riskier segments of the bond market fared better. The S&P U.S. Aggregate Index—designed to measure the U.S. bond market by capturing U.S. Treasuries, agencies, mortgages, and investment-grade corporate bonds—posted its best return of the decade with a 7.4% return. Looking deeper into segments of the bond market, what was extraordinary was the depth and breadth of positive returns in the U.S. as well as globally. The S&P U.S. Dollar Global Investment Grade Corporate Bond Index posted the strongest return among the aggregate sectors. The 12.7% return was the highest among investment-grade sectors and just shy of the 14.3% return high-yield investors earned.

The lowest return was found in mortgage-backed securities, well above the 2.7% starting yield of the S&P U.S. Treasury Current 10-Year Index. The S&P U.S. Treasury Bond Index’s total return more than doubled that level, posting a 6.2% return. Maintaining a position in these markets allows the collection of both principal and coupon payments, contributing to the total return, while benefiting from price appreciation, as the S&P U.S. Treasury Current 10-Year Index rallied 83 bps to close at 1.9%.

Looking ahead, a starting yield below 2% could signal trouble in 2020. 2013 was the last year yields started below 2%, and all sectors of the S&P U.S. Aggregate Index finished the year in the red. In 6 of the past 10 years, the current 10-year yield started below 2.5%. The average returns for every segment significantly underperformed their long-term averages, while years starting with yields above 2.5% saw outsized gains across the board (see Exhibit 3).

Every year, certain trends take centre stage and help to explain market returns. For example, expectations over trade negotiations and Fed policy were useful for explaining market performance in 2019.  Many of these developments often appear obvious with the benefit of hindsight, but identifying the trends and their subsequent impact in advance is far from easy: there are countless possible scenarios, each with its own distinct outcomes.

Given the inherent difficulties of forecasting, it may be helpful for market participants to focus on forming return expectations about market segments that represent a relatively large portion of their respective universes. Correctly predicting trends that influence these areas is likely to be more relevant to a wider range of investment theses, and so may be more meaningful in explaining subsequent returns.

Although definitions of “the Market” can vary depending on one’s investment objective and area of domicile, having a U.S. view is vital in a global equity context.  Indeed, U.S.-domiciled companies accounted for over 50% of the market cap in most S&P Global BMI industries at the end of 2019, and so trends impacting these companies will be relatively important in driving global equity market returns.  Exhibit 1 also suggests that global investors may have to turn to the U.S. for certain exposures (such as Information Technology), which could help them alleviate some of their domestic sector biases.

Of course, any talk of the U.S. in 2020 is likely to lead quickly to discussions about the November Presidential election.  But before concluding that a given result will be entirely positive or negative for U.S. equities, it is worth remembering that different market segments have reacted differently to prior elections.  For example, there was a tremendous increase in S&P 500 sectoral dispersion around the 2016 U.S. Presidential election as the anticipated policies from the incoming administration were expected to have varied impacts on companies in different market segments – this was the beginning of the so-called “Trump trade”.  As a result, it may also be useful to have a view on the various components of the U.S. equity market.

The sizeable representation of U.S. companies in global equity markets means that having a view on the U.S. is likely helpful for explaining performance.  And while we’ll have to wait and see which trends emerge, the rise in sectoral dispersion around the 2016 U.S. Presidential election may indicate that having a view on sectoral performance could also prove helpful.

While the iconic S&P 500® is one of the world’s best known benchmarks, the S&P Composite 1500 (comprising the S&P 500, S&P MidCap 400®, and S&P SmallCap 600®) covers a broader spectrum of the capitalization of the U.S. equity market. Though the S&P 500 is often used as a measuring stick for large-cap fund performance (and rightly so), the S&P Composite 1500 can be a more appropriate benchmark for funds that are not limited to large-cap stocks.

The performance differences between the S&P 500 and the S&P Composite 1500 are not large, never fluctuating outside a 150 basis point annual spread from 2001 through 2018. The tight tracking is expected; the S&P Composite 1500 is also a market cap based index and as such, the S&P 500 would be the predominant sub index, typically accounting for more than 85% of the S&P Composite 1500. But almost without fail, the direction of the spreads of the S&P Composite 1500 are in sync with those of the S&P SmallCap 600 when measured against the S&P 500. When small caps outperform, the S&P Composite 1500 typically beats the S&P 500, and vice versa.

Our SPIVA scorecards measure the performance of active funds against an appropriate passive benchmark. The S&P Composite 1500’s wider capitalization range makes it an appropriate benchmark for multi cap funds as well as all general domestic funds. In both cases, fund managers underperformed the S&P Composite 1500 in 12 of the 18 years observed—and things have looked particularly bleak in each of the last five years. While 2019 results are not available yet, based on market dynamics, we’d expect the average active manager to underperform again.

In 2019, U.S. equities posted double digit gains, with the S&P 500^® returning 31.49%—its best year since 2013 and second-best in a decade. This continued strong performance highlights the potential difficulty of beating the S&P 500.[1] The question then arises: what strategy (if any) outperformed the S&P 500 in 2019?

Our latest S&P 500 Factor Indices Dashboard details the performance of various passive factor strategies across multiple time horizons. Five factor-based strategies outperformed the S&P 500 in 2019—high beta, quality, buyback, minimum volatility, and value (see Exhibit 1).

We focus on quality—the second-best-performing factor—in this blog. High beta, by definition, tends to deliver higher returns than the broad market in a bullish environment. Because of this, its standing as the best-performing factor in 2019 comes as no surprise. Quality, on the other hand, is a frequently debated factor for which definitions can vary greatly and performance can be cyclical.[2] Therefore, its outperformance in 2019 merits additional insight and analysis.

S&P DJI’s definition of high-quality companies is consistent with Graham and Dodd’s definition of “sustainable earnings power.”[3] We measure quality as a composite score of profitability (ROE), low earnings accruals, and prudent usage of leverage (debt/equity). Back-testing, as well as live performance data, show that over a long-term investment horizon, higher-quality companies in the S&P 500 outperformed lower-quality companies and the broad market on both an absolute and risk-adjusted return basis.[4]

Given that the S&P 500 High Quality Index comprises three fundamental ratios, we sought to understand which ratio contributed the most to the index returns. Exhibit 2 shows the performance of each of the underlying ratios—ROE, accruals, and debt-to-equity—in 2019.

The market rewarded profitable companies handsomely in 2019. ROE was the best-performing ratio of the three (38.2%), followed by accruals (29.8%), and then leverage (28.1%). In fact, the portfolio of the highest ROE companies outperformed the S&P 500 by nearly 670 bps.

Given quality’s performance against the S&P 500 in 2019, we wanted to dig deeper into multi-factor strategies that incorporate elements of quality in their index construction. For instance, the S&P 500 GARP Index—which combines growth, value, and quality scores to arrive at a portfolio of 75 growth securities with relatively high earnings quality and reasonable valuations—kept pace with the S&P 500 in 2019, returning 31.5%. On the other hand, the S&P 500 Quality, Value & Momentum Multi-Factor Index lagged the S&P 500 and returned 26.2%. The index’s underperformance is partly driven by exposure to the momentum factor (26.25%), which returned less than the broad market in 2019.

In sum, 2019 was a strong year for domestic equities. The S&P 500, a market barometer for large-cap U.S. equities, posted its second-best year in a decade. Quality was one of the few factors that managed to deliver higher returns than the S&P 500. Upon deeper examination, we found that profitability was the biggest return contributor to the quality factor, posting significantly higher returns than the S&P 500. While it may seem like 2019 was a difficult period to beat the S&P 500, our blog highlights that passive factor strategies with exposure to quality performed even better than the S&P 500 in 2019.

[1]   Chris Bennett, “https://www.indexologyblog.com/2020/01/07/from-hard-to-beat-to-nigh-on-impossible/”

[2]   Aye Soe, “https://www.indexologyblog.com/2018/05/23/quality-part-i-defining-the-quality-factor/”

[3]   Daniel Ung, Priscilla Luk, and Xiaowei Kang. “Quality: A Practitioner’s Guide?”. S&P Dow Jones Indices.

[4]   ibid.

The S&P China 500 advanced 12.9% in Q4 2019, an indication that investors shrugged off U.S.-China trade tensions and signs of a slowing economy. The performance was a reversal from losses during the prior two quarters, which had followed an outstanding 23.6% surge in Q1 2019. The full-year result was a welcome contrast to the dismal end to 2018, when trade concerns appear to have peaked.

Chinese stocks generally outpaced emerging and developed equity benchmarks during Q4 2019, as the S&P Emerging BMI gained 11.1% and the S&P Developed ex-U.S. BMI stood at 9.3%. Tallied against the full array of global indices on an annual basis, only the U.S.-based S&P 500^® managed to beat the Chinese benchmark in 2019 (and only by a slim margin; see Exhibit 1).

Onshore China Stocks Lead in 2019

Broadly speaking, onshore-listed China A-shares gained an advantage over offshore stocks throughout 2019; the S&P Access China A gained 34.7% while the S&P China Broad BMI, which includes A-shares at a limited weight, gained a lesser 22.0%. As expected, the S&P China 500 posted performance in the middle of most major China equity benchmarks, given its diversified composition across all Chinese share classes and sectors.

Consumer Staples and Information Technology Led Sectors in Annual Gains; Energy Lagged

All 11 sectors performed positively during Q4 2019, while 10 of these logged YTD gains. Consumer Staples—led by Kweichou Moutai (up 97.6% YTD)—and Information Technology were sector leaders for the year, with gains of 70.5% and 55.4%, respectively. Energy was the sole sector to miss YTD gains, concluding 2019 with a 6.9% loss.

Financials and Consumer Discretionary (pushed higher by Alibaba, up 54.7% YTD)—the two largest sectors of the S&P China 500 by weight—contributed the most to positive performance in 2019. Combined with Communication Services, the next largest, these sectors represented over half of the index’s annual gains, highlighting the knock-on effects of an increasingly robust consumer-based economy.

Substantial Price Appreciation Raises Valuation Metrics

The S&P China 500 trailing P/E moved higher in Q4 to 15.4x, surpassing the 10-year average P/E ratio of 14.0x, as well as rolling 1-, 3-, and 5-year figures, driven largely by substantial price appreciation. Meanwhile, the index’s forward P/E advanced somewhat less drastically from 12.4x in the prior quarter to 13.8x in Q4 2019, reflecting positive increases in earnings expectations.

Despite the recent increase in index valuations, metrics of broader emerging market indices were well within range, as the S&P Emerging BMI trailing P/E stood at 16.6x at the end of Q4 2019. The S&P China 500 dividend yield, meanwhile, decreased from 2.20% to 2.01% on a quarterly basis.