Indexology^® Blog

Success is hard to come by for active managers, as readers of our SPIVA reports know well.  Sometimes what appears to be stock selection skill is in fact simply a byproduct of style drift across the capitalization scale.

A majority of large-cap active managers outperformed the S&P 500 only 3 times in 19 years of SPIVA data.  It’s surprising, therefore, to see that 68% of midcap managers outperformed the S&P MidCap 400 Index last year (and 62% of small cap managers outperformed the S&P SmallCap 600).  In fact, a majority of midcap managers outperformed in each of the past three years.  In those same years, an average of 66% of large cap managers underperformed the S&P 500.

Why are the results so good for mid-cap managers?  It’s possible that smaller stocks are less efficiently priced than the largest companies, so that stock selection in the mid- and small-cap universe is easier; the higher dispersion of midcaps and small caps would support that view.  Or perhaps mid- and small-cap managers are simply more skillful than their large-cap counterparts.

These explanations would be more plausible were it not for the long-term record.  For the 10 years ended December 31, 2019, for instance, 84% of mid-cap and 89% of small-cap managers lagged their index benchmarks.  If smaller companies were an easier game with more astute players, the score would be better than this.

We argue instead that style drift – for example, the ability of a midcap manager to buy large cap stocks – can shed light on mid- and small-cap managers’ success.  In 2019, e.g., the S&P 500 rose by 31.5%, well ahead of the 26.2% gain of the S&P MidCap 400.  A mid-cap manager who tilted his portfolio slightly up the capitalization scale might have been rewarded for doing so.  If our conjecture is correct, we’d expect midcap manager performance to improve whenever the S&P 500 outperforms the S&P 400.  Exhibit 1 shows that to be the case.

Exhibit 1.  Style Drift Helps to Drive Midcap Performance

A majority of midcap managers outperformed the S&P 400 six times, for an overall success rate of 32%.  When the S&P 500 beat the S&P 400, however, the managers’ success rate rose to 57% (4/7), vs. a success rate of only 17% (2/12) when the S&P 500 lagged.  Alternatively viewed, if the majority of midcap managers outperformed, the 500 usually beat the 400; if the majority underperformed, the 400 was typically in the lead.

Logically, if midcap underperformance creates an opportunity for midcap managers, midcap outperformance might create an opportunity for large cap managers.  Exhibit 2 shows that it does.

Exhibit 2.  Style Drift Helps to Drive Large Cap Performance

Midcaps beat large caps in each of the three years when the majority of large cap managers outperformed, suggesting that large-cap managers might have augmented their performance by tilting down the cap scale.  There were no years when the S&P 500 beat the MidCap 400 and the majority of large cap managers outperformed.

Whenever there are significant differences between the performance of capitalization-specific indices, there are opportunities for managers to add value by moving up or down the cap scale.  So far in 2020, of course, the S&P 500 is well ahead of its smaller counterparts; mid- or small-cap managers might well benefit in next year’s SPIVA data.  Such opportunistic moves may be commendable, but they are not evidence of skill at stock selection.

In the SPIVA^® Japan Year-End 2019 Scorecard, we evaluated the percentage of Japanese active funds that underperformed their respective benchmark indices, as well as the average fund returns on an equal- and asset-weighted basis. Equal-weighted returns are a measure of average fund performance, while asset-weighted returns are a measure of the performance of the total money invested in that category. In certain fund categories, such as the Japanese equity mid/small-cap funds, U.S. equity funds, and emerging equity funds, we noticed significant divergence in the equal-weighted and asset-weighted returns.

Exhibit 1 shows the cumulative equal-weighted performance relative to the asset-weighted performance across these three categories over the 10-year period ending in December 2019. The asset-weighted performance consistently lagged the equal-weighted performance in the Japanese equity mid/small-cap funds category. We also observed similar trends in the U.S. and emerging market equity fund categories between December 2009 and December 2015, though the trend reversed in the past three to four years. When equal-weighted returns outperformed asset-weighted returns, it implies smaller active funds outperformed their peers with larger sizes during the period.

To further examine performance difference between larger and smaller funds for the Japanese equity mid/small-cap fund, U.S. equity fund, and emerging equity fund categories, we bucketed the funds into three tertiles based on each fund’s assets and tracked the tertiles’ performance for each category over the past five years.[1] The top tertile in the Japanese equity mid/small-cap fund category had five-year average total assets[2] of JPY 1,355 billion, accounting for 83% of average assets in the category, while the top tertile in the U.S. and emerging equity fund categories had five-year average total assets of JPY 1,175 billion and JPY 718 billion, accounting for 83% and 95% of average assets in their respective categories (see Exhibit 2).

In the Japanese mid/small-cap fund category, the third tertile (comprising funds with the smallest assets) outperformed the first and second tertiles, which further confirmed smaller funds outperformed larger funds in this category, and all three tertiles outperformed the benchmark over the past five years. In contrast, the top tertile (comprising funds with the largest assets) outperformed the second and bottom tertiles in the U.S. and emerging equity funds categories, showing larger funds outperformed their smaller peers in these two categories, though all three tertiles underperformed their respective benchmarks in the past five years.

These observations indicate pronounced small-cap premia was consistently captured by smaller funds in the Japanese mid-/small cap equity funds. For larger-sized funds, fund managers’ investment proposition may involuntary dip toward stocks with lower return potential due to the selection constraints to pick stocks with larger market capitalization and sufficient trading liquidity, aiming to construct lower-turnover strategies.[3] In contrast, smaller-sized fund categories had much more flexibility to chase investment pools of stocks that offered higher return premia in lieu of lower liquidity or float market capitalization. In addition, this also implies the economies of scale advantage played a less-prominent role in the outperformance of the Japanese equity mid/small-cap fund category.

1 Funds are dissected in tertiles based on assets for each month over the period from Dec. 31, 2014, to Nov. 30, 2019. The top 1/3 of funds with the highest assets are included in the first tertile, while the bottom 1/3 of funds with the smallest assets are included in the third tertile.

2 Five-year average total assets are the average monthly figures of total fund assets in each tertile within each respective SPIVA category for the period from Dec. 31, 2014, to Nov. 30, 2019.

3 Jeffrey, A., Busse, Tarun, Chordia, Lei, Jiang, and Yuehua, Tang (2014). “How Does Size Affect Mutual Fund Performance? Evidence from Mutual Fund Trades.” Research Collection Lee Kong Chian School of Business

Amid Losses, Shariah-Compliant Benchmarks Beat Conventional Counterparts by Substantial Margins

Global equities fell 22.3% during Q1 2020, as measured by the S&P Global BMI, with COVID-19 taking center stage and cases growing worldwide. The S&P Global BMI Shariah—which fell 17.2%—markedly outperformed its conventional benchmark by more than 500 bps, marking its greatest quarterly outperformance since inception. The trend played out across all major regions as the S&P 500® Shariah outperformed its conventional counterpart by 2.7%, while the Dow Jones Islamic Market (DJIM) Europe and DJIM Emerging Markets each outperformed their conventional benchmarks by more than 8.0%.

Sector Performance Acts as a Key Driver

Amid the tough backdrop, broad-based Islamic indices outperformed their conventional counterparts by a substantial margin, as Information Technology and Health Care—which tend to be overweight in Islamic indices—outperformed among sectors, while Financials—which is underrepresented in Islamic indices—heavily underperformed the broader market.

MENA Equity Returns Varied  

Following the MENA equities underperformance in 2019, the S&P Pan Arab Composite mimicked steep emerging market declines during Q1 2020, with a loss of 23.4%. The S&P Oman led the way in the region, holding losses at 8.7%, followed by the S&P Qatar, which declined 18.0%. The S&P UAE suffered the steepest losses, falling 30.3%, followed by the S&P Egypt BMI which declined 29.4%.

Shariah-Compliant Multi-Asset Indices Outperform

The DJIM Target Risk Indices—which combine Shariah-compliant global core equity, sukuk, and cash components—outperformed the S&P Global BMI Shariah and DJIM World Index in Q1 2020 across all allocations as diversification away from equities stabilized returns. The comparably more risk averse DJIM Target Risk Conservative Index was the best performer, due to its 80% combined allocation to sukuk and cash during the declining equity environment, ultimately contracting 5.3% during the quarter. Meanwhile, the DJIM Target Risk Aggressive Index suffered the greatest losses—down 16.6%—due to its 100% allocation to a mix of Shariah-compliant global equities, in alignment with the broader S&P Global BMI Shariah and DJIM World Index.

For more information on how Shariah-compliant benchmarks performed in Q1 2020, read our latest Shariah Scorecard.

A version of this article was first published in Islamic Finance news Volume 17 Issue 15 dated the 15th April 2020.

Recently, I read a comment that suggested we skip 2020 altogether. This new decade has not really started well—if only we could jump straight to 2021. Amid the overwhelming impact of the COVID-19 pandemic on public health and on the economy, perhaps what resonates best is that “this too will pass.”

U.S. equities, which serve as a guidepost for the global economy, surpassed prior all-time highs in volatility. VIX^®, also known as the “fear gauge,” has not reached similar highs since the global financial crisis (GFC) in 2008. The higher the uncertainty, the higher the option prices that are used to calculate VIX. The precipitous drop in oil prices following a price war between Russia and Saudi Arabia threatened a collapse of the Energy sector, adding to the uncertainty in the U.S. and globally. Unemployment in the U.S. continued to rise—in the last two weeks of the quarter, nearly 10 million Americans applied for unemployment benefits following the shutdown of thousands of businesses. It’s expected that this number is only a sign of further job losses to come and that unemployment filings will double in the coming weeks. Many impacted businesses are in the travel, entertainment, restaurant, retail, and real estate industries.

What about Latin America? Like a tsunami that started in Asia and then ravaged Europe, COVID-19 and its effects are now flooding the Americas. Despite the closing of borders and quarantines, the pandemic continues to sweep the continent. Governments have started to institute policies to minimize the public health and the economic impact. Similar to the U.S., which has approved a USD 2 trillion stimulus package to help mitigate the effects of the pandemic, Brazil has approved around USD 30 billion. Peru is also reviewing a similar package. In Chile, the president approved a USD 12 billion package. In Argentina, the World Bank will lend USD 300 million in emergency funds. Colombia and Mexico have not yet announced any major economic measures at this time. The question many ask is, will all this be enough? In the midst of uncertainty, the answer depends on how quickly the pandemic recedes and life goes back to normal.

According to S&P Global’s rating analysts, it is expected that the outbreak will push Latin America into a recession in 2020, recording its weakest growth since the GFC. They have also forecast that GDP will contract by 1.3% in 2020, before bouncing back to a growth rate of 2.7% in 2021. Finally, the length of the recession—although potentially worse in some countries—may be much shorter: only two quarters are projected versus six quarters during the GFC.[i]

Latin American markets underperformed global markets during the first quarter. All gains from the previous years were completely wiped out. The S&P Latin America 40 posted the worst quarter on record, ending at -46% in USD terms. In comparison, the S&P 500^®, which also had the worst quarter since 2008, lost 20%.

No economic sector was spared in the rapid downturn, as companies in important industries like energy, mining, and financials were hit hard. The average stock price drop for members of the S&P Latin America 40 was around -45% for the quarter. The Energy sector of the S&P Latin America BMI performed the worst among the 11 GICS sectors (-61%). Health Care had a difficult quarter (-45%), but thanks to its strong past performance, it lost a lot less for the mid-term periods.

Looking at individual markets in local currency terms, Argentina’s S&P MERVAL Index lost 41.5% for the quarter. Brazil and Colombia followed, returning -36% and -32%, respectively, as measured by the S&P Brazil BMI and the S&P Colombia Select Index.

In a sea of red for the quarter, in Mexico some indices were able to stay in the black. The S&P/BMV IPC Inverse Daily Index, which seeks to track the inverse performance (reset daily) of the S&P/BMV IPC, gained 23%. The following three indices also did well: the S&P/BMV MXN-USD Currency Index (26%), the S&P/BMV China SX20 Index (9.4%), and the S&P/BMV Ingenius Index (9.4%). The latter two indices are designed to measure international stocks trading on the Mexican Stock Exchange, and their strong performance is largely driven by the depreciation of nearly 20% of the Mexican peso relative to the U.S. dollar in Q1.

The first quarter is done, and the second quarter is looking gloomy. Comprehensive relief efforts are underway to help citizens and support our economies, and we can only hope for the best while we continue to tread carefully.

For more information on how Latin American benchmarks performed in Q1 2020, read our latest Latin America Scorecard.

[i] Elijah Oliveros-Rosen, For Latin America, The Path To Economic Recovery From COVID-19 Remains Uncertain, March 31, 2020.

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.