Indexology^® Blog

Why are the market environments most conducive to generating positive absolute returns the least conducive to producing positive relative returns? Explore the active manager’s conundrum with S&P DJI’s Craig Lazzara and Anu Ganti.

Read more here: https://spdji.com/research/article/the-active-manager-s-conundrum

The Australian technology industry roared back to life following a steep first quarter selloff. After peaking on Feb. 17, 2020, the S&P/ASX All Technology Index plunged 46.8%, bottoming on March 23 at the height of the pandemic-led market selloff. Around this time, however, investors realized that Australia’s technology-oriented companies—many of which are involved in innovative payment processing solutions, software development, and in supporting e-commerce across various industries—were likely to be less affected by—and may even benefit from—the pandemic-related economic and social dislocations.

Between the low on March 23 and June 19, 2020, the index gained a whopping 84.4%, leaving it just 2% off its all-time high and up nearly 10% YTD. Meanwhile, the broad market S&P/ASX 200 remained down about 10% for the year. As illustrated in Exhibit 1, the S&P/ASX All Technology Index outperformed all major sectors of the Australian stock market by a wide margin YTD and over the past 12 months.

Broad-Based Contribution Drove Index Rebound

Drilling down into stock-level performance, we can see that although Afterpay was a clear standout, gaining nearly 560% and accounting for about one-quarter of the index’s total return since the March 2020 low, the overall rebound in index performance was broad based. In fact, all 46 constituent companies posted positive returns between March 23 and June 19, 2020, and about one quarter of the total index return was generated by companies outside of the top 10 contributors.

Addition of Seek Headlines First Post-Launch Index Rebalance

The S&P/ASX All Technology Index underwent its first rebalance since launching in February 2020, and the review resulted in five company additions and one deletion. Best known for its online job matching platforms, Seek was added to the index following its GICS reclassification from Human Resources and Employment Services, which is not eligible for inclusion, to Interactive Media and Services, which is eligible. With a float market cap in excess of AUD 7 billion, Seek entered the index as the third-largest constituent with a weight of 8.7%. Nitro Software and Tyro Payments, both of which went public in December 2019, were also added, as were RPMGlobal Holdings and Temple & Webster Group. Over the Wire Holdings was the only existing constituent dropped from the index.

Exhibit 3 illustrates the index composition changes between the end of 2019, the close of June 19, 2020, prior to the rebalance, and the open of June 22, 2020, which reflects the rebalance changes. Afterpay’s nearly 90% YTD share price gain propelled it to the top position, as its index weight nearly doubled. The rise of NextDC from ninth to sixth place was also notable. Finally, the addition of Seek helped to improve the diversification of the index, reducing concentration among the largest components.

The combination of solid returns, the addition of Seek and new technology IPOs has further increased the depth and breadth of Australia’s technology industry. As of June 22, 2020, the total market cap of the S&P/ASX All Technology Index was nearly AUD 116 billion, up 26% from the end of 2019 and nearly double the AUD 63 billion reached at the end of 2018. The index also reached an all-time high in the number of constituents at 50.

It’s been a wild ride since the launch of the S&P/ASX All Technology Index in February 2020. However, the Australian technology industry has been resilient and clearly demonstrated its role as a unique, high-growth area of the Australian equity market during difficult times.

In recent years, one noticeable development in the corporate bond market has been the rapid growth of the BBB bond market in terms of its absolute amount and relative share of investment-grade corporate bonds. We wrote a blog on this topic in May 2019 detailing the growth of the BBB bond market and its impact on the credit fundamentals of the overall investment-grade bond sector. As of May 2020, BBB corporate bonds grew by 214% to USD 3.6 trillion over the past 10 years, while their share in overall investment-grade bonds increased from 38% to 54%.

Prior to the recent market turmoil due to COVID-19, the rapid increase of BBB bonds had already raised concerns among investors that the high-yield bond market might have difficulty absorbing a wave of potential downgrades with a credit market correction. Some investors have been paying closer attention to the rating outlooks for BBB bonds to monitor their overall credit quality. In this blog, we review the historical composition of BBB bonds with negative credit outlooks and the annual transition of bonds that started the year with BBB ratings but were downgraded to join the high-yield bond index by year-end. The BBB bond and high-yield bond universes are represented by the S&P U.S. Investment Grade Corporate Bond BBB Index and S&P U.S. High Yield Corporate Bond Index, respectively.

Exhibit 1 compares (1) the share of BBB bonds with a negative S&P Global ratings outlook at the beginning of the year and (2) the share of BBB bonds that were downgraded to join the high-yield bond index by year-end. Historical data since 2007 shows that, as expected, BBB bonds with a negative rating outlook were not always downgraded to a high-yield rating within a year’s time (2010-2015). However, as of June 16, 2020, 2.5% of BBB bonds had been downgraded to high-yield bonds since the beginning of the year, higher than the average of 1.0% over the past three years.

Exhibit 2 shows the annual transition of BBB bonds to the S&P U.S. High Yield Corporate Bond Index from the beginning of the year to the end of the year. The share of BBB bonds that were downgraded to below an investment-grade rating has been on the rise since 2019. As of June 16, 2020, 5.2% of the S&P U.S. High Yield Corporate Bond Index came from the S&P U.S. Investment Grade Corporate Bond BBB Index as of the end of 2019, the highest since 2009 and 2016. These fallen angel bonds from the BBB rating alone have added USD 88 billion of supply to the high-yield bond universe so far this year. Exhibit 2 also shows that as of June 2020, the share of BBB Bonds with negative credit outlook from S&P has gone up to 20% compared to 6% from the beginning of the year.

The credit market has seen a significant widening of spreads during the COVID-19 selloff. With the Fed’s aggressive measures of purchasing corporate bonds and ETFs, credit spreads have retraced 83% and 72% of the recent widening in the investment-grade and high-yield bond markets, respectively, as of June 16, 2020. However, as Fed Chairman Jerome Powell warned this week, a full U.S. economic recovery will not occur until the pandemic has been brought under control, and significant uncertainty remains about the timing and strength of the recovery. A slow economic recovery combined with plunging oil prices should keep pressure on credit quality and rating downgrades. Rating downgrades in BBB bonds particularly could contribute meaningfully to the supply of high-yield bonds and need to be closely monitored.

In March 2020, the S&P Global BMI TR declined 14.3%, marking its third-worst month over the past 25 years. Meanwhile, some sectors within the index recorded significant outperformances compared with the broader market. The S&P Global BMI Health Care, S&P Global BMI Consumer Staples, and S&P Global BMI Utilities surpassed the benchmark by 9.9%, 8.9%, and 2.4%, respectively.

Since Dec. 31, 1994, the global equity market has experienced four severe downturns when the S&P Global BMI TR declined 20% or more. However, three sectors—consumer staples, health care, and utilities—stayed in positive territory during all the drawdowns. Exhibit 1 shows how these sectors performed during the four worst drawdown periods. While the broader market suffered an average 40% loss, the gains from consumer staples, health care, and utilities sectors averaged 26%, 16%, and 15%, respectively.

Over the long run, the consumer staples, health care, and utilities sectors generated the highest excess risk-adjusted returns. From the end of 1994 through May 29, 2020, the risk-adjusted returns from the consumer staples, health care, and utilities sectors were 0.83, 0.87, and 0.61, respectively, greatly exceeding the benchmark’s 0.50. In addition, as shown in Exhibit 2, the three sectors produced significant excess returns over almost all investment horizons. One year through 2020, consumer staples, health care, and utilities have delivered risk-adjusted returns of 0.0.25, 1.28, and 0.18, respectively, compared to the 0.20 generated by the benchmark.

The underlying business models helped to make the consumer staples, health care, and utilities sectors less sensitive to economic cycles and more resistant to the market downturns. The consumer staples sector includes companies that provide goods and services such as food, beverages, and non-durable household products. The health care sector is composed of companies that provide medical and related products and services, and the utilities sector comprises companies that produce and deliver electricity, gas, or water to their customers. The products and services in these sectors are essential items that people need during all phases of the economic cycles, regardless of financial conditions. The stable demand can help these sectors generate steady revenues under various economic situations. As shown in Exhibit 3, the betas over various investment horizons indicate that these sectors were much less sensitive to the market.

The consumer staples, health care, and utilities sectors have had strong performance during the market slowdowns when observed over the short and long term. Understanding the sector characteristics, performance, and volatility profile can help investors decide on appropriate investments, participate in growth opportunities, and benefit during challenging times.

The evolution of indexing is one of the most noteworthy trends in modern financial history. The rise of passive investing is the consequence of shortfalls in active performance, as regular readers of our SPIVA reports will recognize.

Our recent annual Survey of Indexed Assets shows a surge in S&P 500 indexed assets to $4.6 trillion as of December 2019. Exhibit 1 illustrates that the growth in assets tracking the S&P 500 dwarfed the growth due to market gains, indicating a substantial increase in flows.

To provide context, we can analyze indexed assets historically as a percentage of float adjusted market capitalization. Exhibit 2 shows that this percentage has grown dramatically, from 10% in 1996 to 17% in 2019, highlighting the increasing importance of index funds to the overall market.

One of the reasons for the popularity of indexing is its low cost relative to active management. As indexing has grown, investors have benefited substantially by saving on fees and avoiding underperformance.  We can quantify the fee savings each year by taking the difference in expense ratios between active and index equity mutual funds, and multiplying this difference by the total indexed assets for the S&P 500, S&P 400, and S&P 600.  When we aggregate the results, we observe in Exhibit 3 that the cumulative savings in management fees over the past 24 years is $320 billion .