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A Changed World

What Can S&P DJI's Custom Indexing Do For You?

Why Did Dividend Indices Underperform during the Coronavirus Sell-Off?

Municipal Bonds Are Being Left Behind

Is Passive Investing an Evergreen Option in India?

A Changed World

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Fei Mei Chan

Director, Index Investment Strategy

S&P Dow Jones Indices

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The world looks much different than it did three months ago. Since then equities hit their all-time peak, entered a bear market, exited a bear market, and currently sit 15% off peak with sustained higher volatility levels.

The latest rebalance for the S&P 500 Low Volatility Index®, effective after the close of trading today, rotated out 64 names in the index (63% in weight). For context, the median annual turnover for the last 28 years has been 64%. This quarter’s turnover is notable not just for its size, but also because of some large shifts in sectoral allocation, as shown in Exhibit 1. Low Vol’s weighting in Utilities fell by 21%, Real Estate by 16%, and Financials by 11%, while Health Care (+21%) and Consumer Staples (+13%) witnessed double-digit gains.

By design, Low Vol favors the least volatile sectors, with no arbitrary constraints. This latest rebalance is a good demonstration of how dynamic the index can be, and its size is a function of two things. First, all factor indices are subject to drift. They best embody the factors they’re designed to track immediately after they’re rebalanced. In periods of high dispersion, factor drift is especially likely, and dispersion in the S&P 500 hit near-record levels in March.

Second (and unsurprising in view of the level of dispersion), the volatility of the S&P 500 also spiked since Low Vol’s last rebalance. Importantly, although all sectors were more volatile, the increase was uneven. Exhibit 2 shows, e.g., that the increase in intra-sector volatility for Energy was especially dramatic, and that for Health Care and Consumer Staples more muted.

 

The posts on this blog are opinions, not advice. Please read our Disclaimers.

What Can S&P DJI's Custom Indexing Do For You?

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Our custom index solutions empower clients to achieve any strategy by bringing their investment ideas to life. Find out why ETF sponsors, derivative desks, financial advisors, self-indexers, structured product teams, exchanges, and plan sponsors around the globe turn to S&P DJI for their custom needs.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Why Did Dividend Indices Underperform during the Coronavirus Sell-Off?

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Tianyin Cheng

Senior Director, Strategy and Volatility Indices

S&P Dow Jones Indices

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Over the past 20 years, the S&P 500® experienced three bear markets with drawdowns greater than 30%—the 2000-2001 Tech Bust, the 2008 Global Financial Crisis (GFC), and the ongoing coronavirus sell-off.

During both the Tech Bust and the GFC, various U.S.-focused dividend indices outperformed the S&P 500. However, during the coronavirus sell-off, most dividend indices underperformed the S&P 500 (Exhibit 1).

The goal of this blog is to examine the characteristics of those dividend indices and factor(s) that contributed to the broad underperformance this time around.

  • Not All Dividend Indices Are Created Equal

Each dividend index family has its own unique characteristics and is constructed with the goal of meeting its investment objective.[1] These indices have varying degrees of quality incorporated into their methodology, and can be incorporated into three broad categories: dividend growers, yield/quality blend, and high yielders.

While the indices are expected to have significant exposure to dividend yield, differences in construction among the indices can lead to differing primary and secondary risk exposures. Using a risk model, the fundamental exposures of U.S. dividend indices were examined relative to the S&P 500 over a period of 20 years from Dec. 31, 1999, to April 30, 2020.

The expected trade-off between yield and quality is such that indices selecting higher-yielding constituents tend to have lower relative profitability and higher debt, and a higher risk of falling into the “dividend traps[2].” Indices that focus on dividend growers or blend yield with measures of quality tend to have lower dividend yield, but dividends tend to be more sustainable because of lower debt and higher profitability characteristics.

Exhibit 3 shows that all the dividend indices had lower exposure to volatility than the benchmark. Additionally, upon examining the exposures to the size factor, it is evident the indices had considerable tilt to small-cap stocks; this comes as no surprise, as the indices are either modified market cap-weighted, equal-weighted, or yield-weighted. The last point to note is that all indices were exposed to low growth stocks.

Historically in bear markets, lower volatility and higher quality stocks have tended to outperform the overall market and those stocks with higher volatility and lower quality (Ung & Luk, 2016). Given the factor exposures, it is expected that indices in the dividend growers and yield/quality blend categories would fare better than indices in the higher-yielding category during bear markets. This is largely consistent with what was observed during the Tech Bust and GFC.

In terms of sector exposure, Exhibit 4 shows that all of the dividend indices in the analysis were considerably underweight the Information Technology sector. Sector exposures are more balanced for dividend growers compared to other strategies, which tend to have positive exposure to Utilities and Real Estate. As defensive sectors tend to perform better than cyclical sectors in bear market, similar conclusion can be drawn from the factor exposure based analysis.

  • How Is It Different This Time?

While each scenario had different circumstances and causes, the coronavirus sell-off is driven by the simultaneous exogenous shocks of the pandemic and the oil market collapse. The forced shutdown of the global economy and spillover effect of oil price shock led many companies globally to announce a number of changes to their dividend programs in order to preserve cash.

From a factor performance point of view, the coronavirus sell-off resulted in a number of factors behaving unconventionally. For example, low volatility and low beta factors, which are typically defensive, did not have an outsized outperformance, while growth outperformed value (see Exhibit 5). The abnormal behaviors exhibited by these factors led to the relative underperformance of dividend indices between the Feb. 19, 2020, peak and the March 23, 2020, trough.

Moreover, from a sector perspective, the typically defensive Utilities sector underperformed; while Information Technology outperformed. These contributed further to the broad underperformance of dividend indices. Exhibits 6-8 show the return attribution analysis by factor and sector for each of the three bear markets.

Indices that focus on dividend growers or blend yield with quality shielded investors from large losses during the Tech Bust and GFC, but not during the recent Coronavirus sell-off. The reversal in performance could be explained to some extent by the unconventional behavior of some factors (volatility and growth) and sectors (Utilities and Information Technology).

References

Ung, D. a. (2016). What’s in Your Smart Beta Portfolio? A Fundamental and Macroeconomic Analysis. The Journal of Index Investing, 49-77.

[1] https://www.indexologyblog.com/2020/05/12/sp-djis-dividend-indices-the-importance-of-incorporating-quality-screens/

[2] A dividend trap occurs when a high dividend yield attracts investors to a potentially troubled company.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Municipal Bonds Are Being Left Behind

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Jason Giordano

Director, Fixed Income, Product Management

S&P Dow Jones Indices

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Corporate bonds have garnered a lot of attention lately, as the Federal Reserve continues to stabilize markets by establishing multiple facilities that support both the primary and secondary corporate bond markets. As a result, credit spreads have tightened significantly from where they were in March. Since March 23, 2020, the option-adjusted spread on the S&P U.S. Investment Grade Corporate Bond Index tightened more than 150 bps, and yields were within only 50 bps of their all-time lows as of April 30, 2020.

Meanwhile, municipal bonds experienced greater spread widening in March and did not see the extreme tightening that investment-grade corporate bonds did. As of April 30, 2020, the yield of the S&P National AMT-Free Municipal Bond Index was still more than 100 bps above its pre-COVID-19 low.

Given the recent rally in the corporate bond market, the tax-equivalent yield (TEY) of the S&P National AMT-Free Municipal Bond Index now exceeds the yield of the S&P U.S. Investment Grade Corporate Bond Index. Less than two months ago, the yield-to-worst of corporate bonds was more than 50 bps higher than the TEY of the S&P National AMT-Free Municipal Bond Index. Exhibit 1 compares the yield of the two indices over the past three years.

Muni Credit Quality Remains High

On April 27, 2020, the Federal Reserve announced it would be expanding its Municipal Lending Facility to provide support to smaller municipalities and local governments, as well as extending the duration of bonds it will cover. Undoubtedly, issuers of state and local debt will have to grapple with potentially large budget gaps as income tax, sales tax, and other revenue sources have been severely affected by the virus fallout.

However, the overall credit quality of the municipal bond market is much better positioned to weather such potential hardships. Exhibit 2 compares the credit quality distribution of the S&P National AMT-Free Municipal Bond Index to that of the S&P U.S. Investment Grade Corporate Bond Index. While 55% of the investment-grade corporate bond market is ‘BBB’-rated, less than 9% of municipal bonds fall into the lowest rung on the investment-grade ladder.

Compared to corporate bonds, market participants can find relatively competitive yields in the municipal market while also benefitting from much higher credit quality. Additionally, as corporations continue to cut or suspend dividends for an unknown length of time, increasing exposure to municipal bonds provides participants with an opportunity to potentially supplement that missing yield.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Is Passive Investing an Evergreen Option in India?

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How can indices help inform and simplify decision making in the current climate? S&P DJI’s Koel Ghosh explores potential roles indexing could play when allocating for desired outcomes during COVID-19 and beyond.

Read more here: https://www.indexologyblog.com/2020/04/14/passive-investing-an-evergreen-option/

The posts on this blog are opinions, not advice. Please read our Disclaimers.