Indexology^® Blog

John C. Bogle is quoted as saying, “the idea that a bell rings to signal when investors should get into or out of the market is simply not credible. After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.”[1]

The current COVID-19 situation has created an unprecedented outlook that calls for reinvention and new solutions. Markets across asset classes are witnessing substantial volatility, which is making investment decisions more challenging. Each asset class with its own characteristics is highlighting trends, which is keeping investors perplexed.

Comparing some global trends with those from India for the one-year period ending March 31, 2020, the S&P BSE SENSEX touched historical lows, just as other global indices such as the S&P 500^® have. On the fixed income side, the S&P BSE India 10 Year Sovereign Bond Index has held its ground and been range-bound, though it has also seen some minimal declines. The S&P GSCI All Crude, a subindex of the S&P GSCI that is designed to measure the performance of the crude oil commodity market, recorded its 10-year low on April 1, 2020. The S&P GSCI Gold, a subindex of the S&P GSCI that is designed to measure the performance of COMEX gold futures, rose in March 2020 but with some volatility.

Selecting the best route or time to park funds in such times is a challenge for even the best professionals in the field with years of experience. Passive investing or index-based investing has many benefits that make it an evergreen option in asset allocation. Index-based investing provides allocation to a broadly diversified portfolio at a low cost. An index, based on transparent rules by an independent provider, offers a standard approach without the bias of a fund manager. Passive investing involves the buying and holding of a basket of securities in a particular index in proportion to the securities’ weight in the index, thereby offering protection from concentration risk.

A dilemma faced by many investors is the availability of a plethora of options around them and making the decision of what is the best choice. The best way to counter that is to make the process simple. Indices serve as transparent measures of market compositions and trends, making them essential for building investment confidence. In some cases, indices can make substantial contributions to democratizing market access. Indices define asset classes, geographies, strategies, and themes for the investment community and thereby form the basis of many index mutual funds and exchange-traded funds.

[1] Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor

Active funds generally lagged their passive benchmarks in 2019, but the market environment in 2020 has already shifted radically. Volatility has skyrocketed as the S&P 500^® and other indices have fallen. Ironically, it is precisely in a time such as this, when absolute returns are hard to come by, that relative returns might be most readily attainable. This is true not just for traditional stock pickers, but also for active managers looking to express tactical views on the business cycle through sector rotation.

We can analyze the opportunities available by examining changes in dispersion among sectors and industries. The greater the level of dispersion, the more opportunity there is for active managers to display their skill in sector or industry rotation. Exhibit 1 shows that dispersion among S&P 500 sectors more than tripled in March 2020. We see similar trends for dispersion among mid- and small-cap sectors.

At a more granular level, we observe in Exhibit 2 that dispersion among S&P Select Industries skyrocketed in March, offering immense opportunities for active managers to display skill in tactically rotating among industries.

We can further understand the importance of sectors by decomposing total market dispersion into within-sector and cross-sector effects. Exhibit 3 demonstrates that the contribution of cross-sector effects to total S&P 500 dispersion more than doubled in March 2020, rising above its long-term average, implying that the rewards for skillful sector picks are increasing.

While active managers now have more potential to add value through sector and industry rotation, we caution that greater opportunity for outperformance does not equal actual outperformance. There is also greater opportunity for underperformance. Skill and luck will determine whether active managers achieve glory or embarrassment.

One of the main risks for retirees is not having enough inflation-adjusted income in retirement to support their desired standard of living.  The S&P STRIDE (S&P Shift to Retirement Income and Decumulation)  Indices attempt to solve this problem by focusing explicitly on reducing the volatility of  income rather than reducing the volatility of returns.

In order to help market participants track the cost of a stream of inflation-adjusted retirement income, we recently published our first Cost of Retirement Income dashboard.  (You can sign up for future editions here.)  The dashboard uses the same cost of retirement income measure as our STRIDE indices: the present value of an inflation-adjusted stream of cash flows equal to $1 per year, starting at various retirement dates (vintages) and ending 25 years later.

Exhibit 1 shows that the cost of retirement income increased for all but two S&P STRIDE vintages in the last three months.  For example, the cost of 25 years of retirement income beginning in January 2025 increased from $23.05 to $24.54 in Q1 2020.  Significant market drawdowns in Q1 2020, coupled with declines in U.S. Treasury yields, presented severe challenges for market participants looking to secure a desired level of inflation-adjusted retirement income.  Pre-retirees were particularly impacted given the greater sensitivity of longer-dated vintages to real interest rates, which declined as the U.S. Federal Reserve cut its policy rate in response to the spread of COVID-19.

The dashboard also tracks the hypothetical distributions from post-retirement vintages of the S&P STRIDE indices (see Exhibit 2).  For example, the annualized proportion of last month’s hypothetical distributions – in terms of decumulation points – to the index’s beginning value was 3.26%.  Notably, the decumulation rate is higher than the S&P 500’s 2.34% indicated dividend yield.

Finally, the dashboard reminds us that not all retirement strategies have an explicit focus on providing inflation-adjusted retirement income.  Exhibit 3 shows that nearer-dated S&P STRIDE indices had significantly higher allocations to Treasury Inflation-Protected Securities (TIPS) than the consensus asset mix embodied in the S&P Target Date Indices.  For example, the S&P STRIDE 2020 index’s TIPS allocation (77.2%) was 14 times higher than the S&P Target Date 2020 index (5.5%) at the end of March 2020.  This is a result of the S&P STRIDE indices’ focus on income rather than return volatility, and it impacts asset allocations across the traditional glidepath approach.

For more information, please see the S&P STRIDE Index Series Methodology and the S&P STRIDE Supplemental Data Guide.

Much has been made of the relative performance of gold since the start of the global COVID-19 pandemic. The S&P GSCI Gold gained 10.2% YTD through April 7, 2020, highlighting its safe-haven status; however, it is worth reviewing this performance and considering what demand drivers may influence gold prices over the coming months.

The generally held belief is that gold is negatively correlated to equities during extended bear markets, but it is not unusual for gold, and other putative safe havens, to retreat in unison on big down days in the broader market. Gold’s high liquidity makes it an attractive component of a portfolio to sell in times of urgent need for cash, such as when meeting margin calls. This is what occurred in March 2020. The spike in volatility would also have forced investors to cut the overall size of risk-adjusted positions.

It is worth remembering that gold had already enjoyed a surge in investor interest prior to the current crisis, on the back of low to negative interest rates across the globe and a myriad of geopolitical flare-ups.

As for the demand side of the equation, there is plenty of uncertainty in the near term. Jewelry demand, which accounted for approximately 50% of all demand for gold in 2019, has undoubtedly fallen since the start of the year, but it is too early to say by how much. The World Gold Council estimated that Chinese consumer demand fell 30%-50% year-over-year in Q1 2020. Many also expect that jewelry demand in the West will not perform as strongly in the current economic climate.

Central bank buying is even more uncertain, with oil-rich nations negotiating the impact of a collapse in energy prices, and other global sovereigns looking to fund large stimulus packages to mitigate the impact of the current economic downturn.

Investor demand for gold is expected to remain strong, although from a portfolio construction and diversification standpoint, there will be a point at which large investors choose not to add to their gold holdings. The massive fiscal and monetary response by governments to manage, and hopefully lessen, the financial impact of the pandemic has triggered inflationary concerns among some investors. As a hedge against inflation, gold is still viewed by many market participants as the “currency of last resort.”

The supply-side implications should not be ignored. Disruptions to the flow of physical gold between London and New York has already caused some disturbances to the usually stable differential between London Spot and COMEX futures price and led to the launch of a new futures contract that allows for the delivery of a wider choice of gold bars. There has also been a notable disruption to mine supplies that will flow through to the market.

S&P Dow Jones Indices offers a variety of gold-related indices, including the S&P GSCI Gold, S&P WCI Gold, S&P Commodity Producers Gold Index, and S&P GSCI Gold Dynamic Roll 70/30 Futures/Equity Blend (USD).

The U.S. stimulus bill (the CARES Act) enacted on March 27, 2020, received significant attention for its support payments to individuals. However, it also has a significant impact for large corporations (see Exhibit 1).

This blog will take a closer look at two lending programs and their market impact within their respective segments.

CARES Act: Liquidity Where It’s Needed

The first program[i] is for loans and guarantees made through the U.S. Treasury or Federal Reserve for up to five years, at prevailing market rates prior to the outbreak. While this is welcome liquidity, it comes with a few restrictive covenants.

• Companies must maintain 90% of their pre-virus employment and may not pay dividends or repurchase stock until 12 months after the loan terminates.
• Only companies with “significant operations” and a “majority of employees” in the U.S. are eligible.

This means that companies that change their finance policies to access these loans may signal they have no other funding options available.

The U.S. Treasury will also provide financing[ii] to lenders to make direct loans at rates of 2% or less to businesses with 500-10,000 employees. Furthermore, for the first six months (or longer, at the Treasury’s discretion), no principal or interest shall be payable, though restrictions like those mentioned above remain in place here too. However, the distinction here is that the second program could significantly enhance the borrowing capacity of high-quality mid-sized companies, without needing to change their financing policies or signaling distress (given its accessibility through lenders or intermediaries).

This leads us to the following considerations.

• First, below-market rates are welcome from a liquidity perspective.
• Second, as we go down the market-cap scale, companies are more likely to have more than 50% of their employees based in the U.S., which would qualify them for this program.
• Lastly, most of these qualifying companies with 500-10,000 employees are well represented across the core U.S. size indices.

Quality Matters in Times of Stress

The S&P Quality Indices consider ROE, accruals ratio (operating asset efficiency), and financial leverage to select higher-quality constituents. Our quality indices broadly outperformed during the recent sell-offs, while remaining competitive in the subsequent rebound and the previous 12-month run.

Similarly in small caps, the S&P SmallCap 600’s historical benefits over the Russell 2000 show that the index can provide small-cap exposure but with better quality through the profitability screens utilized in the S&P SmallCap 600 methodology.

Fixed Income

The bond market has long included its own proxy for quality, dividing assets into investment grade and high yield. The spread between the two has blown out recently, even with rates on Treasuries dropping. The Fed’s Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF), which are buying investment-grade bonds directly from issuers and in the market, has aided this flight to quality. The moves in yields and spread neatly illustrate the market’s updated expectations of enhanced survivability odds for investment-grade (quality) firms.

Perhaps, now it’s equities’ turn to focus their attention to where it’s needed most, i.e., quality!

[i] H.R. 116-748, Title IV, Sec 4003, (c)(2)

[ii] H.R. 116-748, Title IV, Sec 4003, (c)(3)(D)