Indexology^® Blog

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.

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.

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/

Since its debut in April 2000, the S&P/ASX Index Series has served as the de facto measure of value and performance for the Australian stock market, becoming an integral part of the country’s market infrastructure. 2020 has tested the resilience of that infrastructure; as pandemic fears gripped financial markets, stocks ricocheted, and trading in index-linked instruments spiked. During this period of volatility, the S&P/ASX Index ecosystem provided crucial liquidity to market participants.

In Q1 2020, many market participants used the most liquid, transparent instruments available to manage their exposure to equities. Futures, options, and exchange-traded funds (ETFs) linked to the S&P/ASX Index Series saw record trading volumes, with over AUD 1 trillion in index-linked trading during the first quarter—a 50% increase from the first quarter of 2019. Trading was mostly concentrated in products tracking the S&P/ASX 200, but products tracking other S&P/ASX Indices saw larger relative increases, with trading tripling year-over-year in products associated with the S&P/ASX 300 and the S&P/ASX Dividend Indices.

Exhibit 1 is updated from our recent paper “Marking 20 Years of the S&P/ASX Index Series,” in which we highlighted the potential liquidity benefits of the ecosystem of tradable products surrounding the S&P/ASX Index Series. We measured the economic value, or index equivalent trading (IET), of futures, options, and ETF trading linked to the S&P/ASX Index Series, in order to capture the value of notional exposure to the underlying index.¹

One of the benefits of higher volumes is the potential for lower trading costs. Products linked to the S&P/ASX Index Series displayed some of the lowest trading spreads of all Australian-linked and Australian-focused ETFs, with products linked to the S&P/ASX 200 typically displaying the lowest spreads of all.

In March 2020, trading costs soared globally, providing the test of record highs in volatility. Across the whole first quarter, average bid-ask spreads were wider across the board for Australian ETFs.

The average bid-ask spread on Australian-listed ETFs linked to the S&P/ASX 200 was 0.17%, while the average bid-ask spread for all Australian-listed and Australian-focused ETFs was 0.75%. Compared to the equivalent figures for 2019, spreads on ETFs linked to the S&P/ASX 200 rose by only 12 bps, while the average was 39 bps.²  Of the five Australian ETFs with the lowest average bid-offer spreads in Q1 2020, four were linked to the S&P/ASX 200, S&P/ASX 50, or S&P/ASX 300 (see Exhibit 2).

Market efficiency is not the gift of a benevolent providence. A trading ecosystem sufficiently large and active can benefit asset owners and investment managers by offering transparency, efficiency, and improving confidence. And as markets reached lows, the importance of liquidity and benefits of a large and trusted ecosystem reached new heights.

¹ See “A Window on Index Liquidity: Volumes Linked to S&P DJI Indices,” (2019), for details of how the IET is calculated for various types of products.

² See Exhibit 10 of “Marking 20 Years of the S&P/ASX Index Series,” (2020), for details on Average Bid-offer Spreads in 2019.

The S&P 500^® Quality, Value & Momentum Multi-Factor Index is designed to measure the performance of stocks having the highest combination of quality, value, and momentum (QVM). It takes a “bottom-up” approach of scoring each stock on its individual factor attributes and selecting stocks that jointly score highest across all the factors [1]. In light of the recent market turbulence, let us examine the performance of this index in comparison with the alternative “top-down” approach to multi-factor portfolio construction, i.e., taking an equally weighted combination of single-factor indices, referred to as an “index of indices” (IOI)[2].

During the recent market sell-off, most of the factor indices declined until they reached a bottom in late March, before rebounding partially over the following month. Exhibit 1 shows the performance of single-factor indices and the two multi-factor combinations. While the S&P 500 QVM Multi-Factor Index’s outperformance over the IOI approach was not massive, it still did provide about 60 bps of excess return in both declining and rising phases of the market.

In order to see if there is any compositional bias that leads to this outperformance, we examine the overlap between the S&P 500 QVM Multi-Factor Index constituents and the individual factor index constituents. We quantify this overlap as the percentage of index weights held in common [3].

Exhibit 3 shows that the S&P 500 QVM Multi-Factor Index tends to have a higher overlap with the quality factor (which has outperformed recently [4]), and a lower overlap with the value and momentum indices. This is partly due to a negative correlation between momentum and value exposures among S&P 500 constituents (see Exhibit 4), which implies that high-quality stocks have a better chance of being selected when constituents are sorted on an average of all three factor scores.

Combining factors in a top-down manner tends to dilute individual factor loadings, since stocks that have a strong positive score on one factor might have a large negative score on another [5].

By picking overall winners across all factors, the S&P 500 QVM Multi-Factor Index held up relatively better than the top-down (IOI) approach during the recent market turmoil. Though the examined time period is relatively short and the excess performance is small, the potential benefits of bottom-up selection still shined through.

[1] https://spdji.com/indices/strategy/sp-500-quality-value-momentum-multi-factor-index

[2] “The Merits and Methods of Multi-Factor Investing” available at https://spdji.com/indexology/factors/the-merits-and-methods-of-multi-factor-investing

[3] Factor dashboard for April 2020, available at https://spdji.com/indexology/factors/get-the-latest-us-factor-returns

[4] https://www.indexologyblog.com/2020/04/22/the-sp-500-quality-index-attributes-and-performance-drivers/

[5] https://www.blackrock.com/institutions/en-axj/insights/factor-perspectives/multi-factor-strategies