Indexology^® Blog

With oil prices falling and the spread of the COVID-19 pandemic, volatility is back in action. In Latin America, Forex valuations are a key barometer. Local currency depreciation is one of the most common reactions to uncertainty (see Exhibit 1).

This blog highlights the recent volatility in the Mexican peso and possible ways to mitigate this risk.

Mexican Peso: Liquidity, but with Volatility

The Mexican peso was the most affected LatAm currency of March 2020. It had the worst monthly return since the “Tequila Crisis” or the error of December 1994 (see Exhibit 2). The March 24, 2020, closing price of MXN 25.1185 per USD 1 was the worst official closing level for the Mexican peso in March.

The Mexican peso is one of the most liquid and deep currencies among emerging markets, frequently used as a vehicle to hedge long positions, as a diversification strategy, and to take bearish tactical positions.

Conclusion: Investors Can Hedge

In the recent Mexican peso sell-off, our S&P/BMV USD-MXN Currency Index, which tracks U.S. dollar-Mexican peso spot rates, sold off; however, its inverse, the S&P/BMV MXN-USD Currency Index, as expected, gained. Having two options for indices measuring these currencies ensures that investors no longer have to just take one side of the trade and can use both sides to tactically hedge.

The S&P/BMV MXN-USD Currency Index returned 20.23% in March 2020 and 25.52% YTD.

For different asset classes, for tactical purposes, for long-term and diversification strategies, for hedging; whatever your needs may be, we likely have an index for that!

Launched in August 2018, the S&P Risk Parity Indices were designed to be a transparent, passive alternative to active risk parity funds. The index series comprises several indices that are differentiated by volatility targets in an 8%-15% range.

This blog compares the original and new methodologies.

After consultations with stakeholders, S&P Dow Jones Indices has updated the methodology, effective April 6, 2020. Under the original methodology, realized volatilities of the indices generally fell below target. However, the new methodology is expected to ensure realized volatility is closer to the target. The S&P Risk Parity Indices rebalance monthly, and unlike the original methodology which uses historical weights, under the new approach the current rebalance weights are applied to get a more realistic estimate of forward volatility.

As Exhibit 1 shows, the original methodology’s realized volatility was short of its target volatility over the back-tested period. This isn’t surprising since the market has mostly experienced declining volatility over the past decade. Moreover, if market volatility had trended in the opposite direction, it is reasonable to expect that the index would have realized above its target.

The new methodology addresses this issue by holding constituent weights constant over the entire 15-year look-back period and using them to calculate volatilities and adjust leverage, thereby, delivering a realized volatility that is closer to the target over long- and mid-term horizons (Exhibit 1).

Relatively higher risk in the new index methodology was more than offset by higher returns, leading to a return/risk ratio of 0.76 compared to 0.66 with the original methodology (see Exhibits 2 and 3).

Lastly, to aid with replication, the index will now use security-specific roll schedules and use S&P 500^® e-mini futures instead of a standard futures contract.

Since the methodology changes have a material impact on historical risk profiles, the entire time series has been restated.

With the above changes we believe the index will realize closer to its target volatility over the long-term.

As the world continues to pump the gas on a one-way street toward catastrophic climate change, market actors are attempting to slow down the traffic by limiting global temperature rise to within 1.5°C since pre-industrial levels.[1] To date, climate-conscious investors have largely focused on reducing relative portfolio carbon exposure. However, divergent methodologies make fertile ground for greenwashing, while point-in-time analyses do not necessarily inform alignment with the low-carbon transition. To address this, the EU is proposing regulation to prevent climate index greenwashing.[2] Global efforts such as the G20’s Task Force for Climate-related Financial Disclosures (TCFD) also seek to enhance transparency with guidance for holistic climate disclosure. A new S&P Paris-Aligned Climate (PAC) Index Concept now offers a powerful tool to address the minimum EU standards for a Paris-aligned benchmark and the recommendations of the TCFD.

Minimum Standards for EU Climate Benchmarks

The EU’s action plan for financing sustainable growth proposes two new climate benchmarks: EU Climate-Transition Benchmarks (CTB) and EU Paris-Aligned Benchmarks (PAB), both using absolute measures to align with a 1.5°C trajectory rather than simply a relative carbon reduction. In 2019, an EU-appointed technical expert group (TEG) published a final report, which contains the proposed minimum standards. The final report will serve as the basis for the European Commission’s drafting of the delegated acts.

TCFD Recommendations

Two years prior, the TCFD released its recommendations for climate-related financial disclosures.[3] These include the financial impacts of climate-related risks and opportunities, comprising transition and physical risks (see Exhibit 2). The latter refers to physical hazards, for instance, more frequent and extreme weather events (storms, hurricanes, floods, etc.), weather pattern shifts, and sea-level rise. Physical risk thereby threatens companies facing asset-write downs, disruptions in supply chains, and costly insurance premiums,[4] whereas transition risk addresses the costs associated with the policy, legal, technological, market, and reputational risks from adapting to climate change. Conversely, the transition will also require USD 1 trillion of investment each year in gainful areas such as low-carbon energy and sustainable products.[5]

However, transition and physical risks are not a priori connected. The failure to transition to a low-carbon economy increases the likelihood and severity of physical risks, while the failure to mitigate physical risks suggests the market is not transitioning. Even under a 1.5°C scenario, physical risks will occur more frequently than at-present. A TCFD-aligned strategy must therefore account for both types of risk and the opportunities arising from climate change.

S&P Paris-Aligned Climate Index Concept

To meet the proposed EU regulation, S&P Dow Jones Indices has devised a new PAC Index Concept,[6] which additionally encompasses further objectives to align with a 1.5°C scenario and the TCFD.

• Transition Risk: The concept weights companies based on their ability to transition in alignment with a 1.5°C scenario, using Trucost data with transition-pathway models endorsed by the Science-Based Targets Initiative. Further measures include 7% year-over-year decarbonization to avoid overshoot, overweighting companies with strong environmental policies arguably better positioned for the transition,[7] overweighting companies that disclose science-based targets,[8] and reducing fossil fuel reserve exposure to mitigate stranded asset risk.
• Physical Risk: The concept achieves a 10% reduction in physical risk exposure using state-of-the-art Trucost data, accounting for geolocation-specific risk and sensitivity of company assets to climate hazards.[9] Dynamic capping of individual company weights based on physical risk exposure also reduces tail risk.
• Climate Opportunities: By improving the green-to-brown ratio relative to the underlying index, the S&P PAC Index Concept exhibits greater exposure to green power generation sectors expected to benefit from the transition.

These objectives are simultaneously incorporated while minimizing deviations from the underlying index, resulting in a broad, diversified index with similar performance to that of the underlying benchmark. The S&P PAC Index Concept thus offers a formidable new tool for meeting the proposed EU regulation—as well as a resilient and holistic approach to addressing climate risks and opportunities, as per the TCFD.

[1]   The aim of the Paris Agreement is to strengthen the global response to the threat of climate change by keeping global temperature rise well below 2°C above pre-industrial levels and to pursue efforts to limit the temperature increase even further to 1.5°C—see here. According to the Intergovernmental Panel on Climate Change (IPCC), climate adaptation will be less difficult under a 1.5°C scenario, as “our world will suffer less negative impacts on intensity and frequency of extreme events, on resources, ecosystems, biodiversity, food security, cities, tourism, and carbon removal”—see here.

[2]   In May 2018, the EU announced proposals to create two new climate benchmarks as part of its action plan for financing sustainable growth. In December 2018, the law creating these new benchmarks was officially enacted via amendment EU 2019/2089. An EU-appointed TEG later published its final report on climate benchmarks and benchmark ESG disclosure in September 2019, containing proposed minimum technical standards for these benchmarks that are still at the proposal stage. The report provides proposals to the European Commission that will be used to prepare the delegated acts.

[3]   See Final Report: Recommendations of the TCFD (June 2017), available here.

[4]   For example, in an attempt to curb global emissions, carbon taxes and emission trading schemes are increasing operating costs for carbon-intensive companies, while the substitution of existing products or technologies to lower carbon alternatives creates technology risk amid possible early retirement of assets. Further, shifts in consumer preferences for low-carbon substitutes and reputational damage to companies that are slow to adapt can erode brand value and ultimately decrease company revenues.

[5]   TCFD Final Report (June 2017), Executive Summary Page ii, available here.

[6]   For full details of the proposed S&P PAC Index Concept, see here.

[7] The S&P PAC Index Concept ensures improved environmental policy credentials, as measured by S&P DJI Environmental Scores. The scores provide insights into financially material aspects of a company’s climate strategy, environmental policy and management systems, electricity generation, environmental business risks and opportunities, low-carbon strategy, recycling strategy, co-processing, and more. To learn more about S&P DJI Environmental and ESG Scores, visit https://spdji.com/topic/esg-scores.

[8]   Subject to the conditions specified by the TEG to prevent greenwashing and encourage disclosure.

[9]   Trucost physical climate risk data covers hazards related to wildfires, cold waves, heat waves, water stress, sea-level risk, floods, and hurricanes. To learn more about Trucost physical climate risk data, see here.

2019 was a remarkable year for risky assets. All benchmarks tracked in the SPIVA U.S. Year-End 2019 Scorecard delivered positive returns. Information Technology-heavy and more internationally diversified companies of the S&P 500^® pushed the index to its second- and fourth-highest annual return since 2001 and 1990, respectively. In addition, the S&P MidCap 400^® (26.2%) and S&P SmallCap 600^® (22.8%) also delivered strong returns.

Active Funds: Strong Markets, Weak Performance

While these tailwinds helped U.S. equity managers, they still didn’t translate into active outperforming passive. Our latest SPIVA U.S. Scorecard shows that 70% of domestic equity funds lagged the S&P Composite 1500^® over the one-year period ending Dec. 31, 2019. This is the fourth-worst performance since 2001.

Large-cap funds made it a clean sweep for the decade—for the 10th consecutive one-year period, the majority (71%) underperformed the S&P 500. Their consistency in failing to outperform when the Fed was on hold (2010-2015) or raising (2015-2018) or cutting (2019) rates deserves special note. Of the large-cap funds, 89% underperformed the S&P 500 over the past decade.

Are Mid- and Small-Cap Managers Truly Outperforming?

Mid-cap funds can claim some swagger when presenting to investment committees: 68% of mid-cap funds beat the S&P MidCap 400 in 2019, the third consecutive year the majority did so. Similarly, 62% of small-cap funds beat the S&P SmallCap 600. However, 84% of mid-cap funds and 89% of small-cap funds underperformed over the longer 10-year period.

However, one reason for the reasonably good performance of mid-/small-cap funds in 2019 could be performance divergence. In 2019, the S&P 500 outperformed the S&P MidCap 400 and S&P SmallCap 600. Arguably, mid-/small-cap managers could have outperformed their respective asset classes by shifting just a bit to larger caps; however, this strategy did not work in the long term because the three benchmarks showed much less divergence in the past 10 years.

Growth versus Value

In the past year, most value funds lagged their benchmarks across all market capitalizations. Over the past decade, however, we saw scant difference between growth and value funds’ likelihood of underperforming their benchmarks

Conclusion

As they say, the proof of the pudding is in the eating. If active managers cannot deliver outperformance over the long term, they should consider not remaining active!

Financial market history is rife with prolonged bull market periods and deep corrections. With no proven way to correctly time the market, market participants can stay fully invested and attempt to capture the potential upside, but they also have to endure and recover from the full depths of drawdowns. Hence, some market participants may choose a tradeoff to mitigate the most severe downside by forgoing a portion of the upside.

We illustrate the intuition behind the tradeoff in a simple analysis. For example, if we had invested USD 1,000 in a portfolio tracking the S&P 500^® in 1970, after 50 years, it would be worth USD 125,458. That number would drop by half to USD 56,389 if we missed the 10 best days, or almost triple to USD 359,233 if we avoided the 10 worst days.

Exhibit 1 highlights varying degrees of hypothetical tradeoffs between upside participation and downside capture—if one were able to capture 10%, 20%, 30% … return on the 10 worst days and 90%, 80%, 70%… return on the 10 best days. For example, the 10/90 Best/Worst % Capture portfolio would capture 10% of the returns on each of the 10 best days and 90% of returns on each of the 10 worst days.

The shape of the tradeoff curve shows that the 50/50 trade-off scenario (green dot in Exhibit 1) outperformed the S&P 500 with lower volatility. This implies that investors can indeed trade substantial upside participation for downside mitigation and still maintain the potential to come out ahead.

This observation is especially relevant for investors relying on their investments for retirement income, as they need protection from short-term drawdowns. Withdrawals for annual living costs make it hard to recover from those losses, and an adverse sequence of market returns may accelerate the depletion of their accounts.

The S&P Managed Risk 2.0 Index Series is designed based on the observation around this trade-off. The indices dynamically adjust the exposure between a risky asset and a reserve asset to target a predefined volatility level and add an additional layer of capital management, with the cost of protection embedded in the strategy and financed through the reserve asset in the form of a synthetic put hedge.

The strategy dials down participation in risky assets when market volatility is high, and hence aims to avoid the most severe down days. In order to achieve this, it gives up some participation in the up market days, as protection comes with costs. When the market is stable, on the other hand, the strategy increases allocation to risky assets and maintains full equity allocation in calm periods.

In the first quarter of 2020, the S&P 500 Managed Risk 2.0 Index demonstrated its potential ability to provide protection. The index quickly de-risked by allocating to safer assets—a change from full allocation to equity on Feb. 20, 2020, to a mere 17% equity allocation as of the end of March 2020. As a result, it maintained volatility at one-third of the S&P 500 and reduced drawdown by half of the S&P 500.

Not only that, the 30-year historical performance showed that the S&P 500 Managed Risk 2.0 Index would indeed provide a much better outcome for retirees, when it is used as a construction tool in a core portfolio.

Following 30 years of decumulation using the back-tested data from March 1990 to March 2020, the account value under the managed risk approach was 111% more than the account value using the traditional 70/30 equity/fixed income blend.  When withdrawals are factored in, the relative excess value generated by the managed risk approach was not merely maintained, but improved upon.

Markets time and time again prove that they are susceptible to large shocks and difficult to time accurately. For those concerned about extreme drawdowns and are willing to give up a portion of their upside potential, strategies such as S&P Managed Risk 2.0 Indices can play a role in smoothing out returns.