Indexology^® Blog

While the COVID-19 pandemic wreaked havoc on global financial markets, it has affected Australian equity sectors quite unevenly. Energy, Financials, and Real Estate have experienced the heaviest losses, while Health Care has outperformed by a wide margin, sustaining a 10% YTD gain through April 9, 2020.

In our recent paper marking the 20^th Anniversary of the S&P/ASX Index Series, we discussed how changes to the composition of the S&P/ASX 200 over the past two decades provide a window into the evolution of the Australian stock market. One key observation made was the outsized growth of the Health Care sector—which increased from a 1% weight in the S&P/ASX 200 in 2000 to just over 10% as of the end of 2019, becoming the third-largest sector in the index behind Financials and Materials.

Fast forward to today, just a few months later, Health Care has increased to nearly 15% of the S&P/ASX 200, approaching the size of the Materials sector. One of its constituents, CSL—the Australian biotech giant—has become the largest Australian company by market value for the first time.

Exhibit 2 illustrates the increasing importance of the Health Care sector in the S&P/ASX 200 over the past two decades, a trend that gained notable momentum over the past 10 years. In fact, since March 2011, the combined weight of Financials and Materials—Australia’s largest sectors—decreased from 59.4% to 45.3%, while Health Care jumped from 3.2% to 14.2%.

At the launch of the S&P/ASX 200 in 2000, the Health Care sector’s total market cap was just AUD 7 billion. As of April 9, 2020, it surpassed AUD 210 billion, representing a compound annual growth rate of about 18.5% over 20 years.

In a nod to the sector’s growing clout, CSL unseated Commonwealth Bank as the largest Australian company by market value in March, thus becoming the top holding in the S&P/ASX 200. Five years ago, CSL was the eighth-largest company, and it first joined the top 10 in 2012.

Because of its size (CSL represents about 70% of the S&P/ASX 200 Health Care sector by market cap) and impressive returns, the overall growth of the sector can largely be attributed to its success. However, other prominent companies in the sector such as Cochlear, Sonic Health Care, and ResMed have also experienced strong long-term total returns. Likewise, sector growth has been largely organic. Each of the top five companies currently in the S&P/ASX 200 Health Care were listed on the ASX in 2000, and the top three (CSL, Cochlear, and Sonic Health Care) were S&P/ASX 200 constituents at launch.

Exhibit 5 illustrates the significant outperformance generated by the S&P/ASX 200 Health Care relative to the S&P/ASX 200 and the other largest equity sectors over the past 20 years. This trend has accelerated since 2012.

While Health Care has come to the forefront during this devastating pandemic, the sector’s recent rise is an extension of a long-term trend that has been unfolding in the Australian equity market for many years.

Q1 2020 ended with record dividend payments for S&P 500^® issues, as shareholders reaped the benefits of a 10-year bull market. March 2020 (and the first six trading days of April 2020), however, gave a glimpse of what Q2 2020 may look like, as dividend cuts and suspensions started to be announced, with suspensions more prevalent. For 2020, liquidity and cost control are now the top priorities, with dividends lower and buybacks an endangered species.

The Good: Q1 2020 dividends set a new record, paying USD 127.0 billion, up from USD 117.0 billion for Q1 2019.

The Bad: March 2020 announcements turned negative, as 13 issues announced cuts, with 10 of them being suspensions, making for a total forward impact of USD 13.9 billion, and more cuts are expected. For U.S. common issues, the net-indicated dividend change was USD -5.5 billion, with the last negative in Q2 2009 (USD -4.9 billion) and the previous record low in Q2 2009 (USD -43.8 billion).

The Ugly: For Q2 2020 to date (the first six trading days), there were 57 actions (none of them S&P 500 issues), with 7 positive and 50 negative, and 40 of the 50 negatives being suspensions, amounting to net change of USD -4.8 billion. As for January’s predicted 2020 double-digit dividend gain for the year, just put a “-” in front of it.

The Full Reality Is Starting: Looking at the announcement dates (typically after the board of directors meetings), the next three weeks will be telling, with the first key test being when the big banks start off the earnings season. Last month, eight banks acted in unison to suspend their buybacks (to date, 27% of the S&P 500 has been cancelled, with 72% of the Financials sector).

The full impact of these cuts will start to be felt soon by investors, as fewer dividend checks are sent out, with many of those going out smaller.

At this point, the depth of the cuts are dependent on the COVID-19 economic impact, and given we don’t know what that will be, companies may be forced to take prudent measures.

It comes as no surprise that the COVID-19 pandemic had a profound effect on global markets in the first quarter of 2020. The S&P 500^® suffered steep declines, and U.S. Treasury yields fell (prices rose) as investors favored a flight to quality. In commodities, the S&P GSCI ended March down an extraordinary 29.4%, the largest monthly drop in performance in its almost 29-year history.

Similarly, the first quarter proved a challenging one for the S&P Risk Parity Indices, with all of the volatility targets posting double-digit losses (see Exhibit 1). This was to be expected given the sudden and dramatic decline in the aforementioned asset classes.

Since their launch in 2018, the S&P Risk Parity Indices have been adopted by several asset owners and asset managers as a benchmark for active risk parity funds. As Exhibit 2 shows, the performance of the S&P Risk Parity Index – 10% Volatility Target was very much in line with the manager composite for the first quarter.

As we continue to analyze the S&P Risk Parity Index – 10% Volatility Target, let’s examine the asset class performance attribution (using excess returns). The S&P Risk Parity Indices comprise three asset class sub-components: equities, fixed income, and commodities.

As Exhibit 3 shows, negative performance for the first quarter was driven by commodities and equities, down 11.7% and 8.9%, respectively. Fixed income finished the quarter up 7.2%, which, despite its comparative weight advantage, was not enough to offset losses in the other two asset classes.

When it comes to weighting assets, risk parity attempts to maximize the diversification benefits by allocating capital such that each asset class contributes an equal amount of volatility to the total volatility of the portfolio. Thus, less-volatile asset classes, like fixed income, are typically assigned a higher weight. Additionally, the index is typically leveraged to meet the stated volatility target to achieve a stable risk profile.

As Exhibit 4 shows, the leverage decreased only slightly in March, but it is anticipated that April will be more pronounced as the impact of March is fully absorbed. That being said, dramatic changes are not expected given the fact that the look-back window on the volatility calculation is fairly long (15 years).

While markets started April on the front foot, we are not out of the woods yet when it comes to uncertainty over the coronavirus. Although the first quarter was a challenging one for the S&P Risk Parity Indices, they still offer the potential to help improve risk-adjusted returns over the long term. By placing each asset class on an equal volatility footing, the diversification benefits have a better chance of shining through compared to traditional fixed allocation approaches.

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.