Indexology^® Blog

2020 has been overshadowed by the COVID-19 outbreak and the subsequent lockdown across the world. Capital markets have been negatively affected globally as well as locally in India. The lockdown in India began during the third week of March 2020 and has only recently been slightly relaxed. The first half of 2020 was volatile for the capital markets in India. All size indices and most sector indices posted negative returns for the six-month period ending June 2020.

Exhibits 1 and 2 showcase the six-month returns for India’s leading size indices for calendar year 2020.

From Exhibits 1 and 2, we can see that the returns for large-, mid-, and small-cap segments for the first six months of 2020 were negative. The large-cap indices posted the lowest returns among the size indices. The S&P BSE SENSEX, which comprises the 30 largest and most-liquid listed companies in India, provided a negative return of nearly -15% over the first half of 2020. However, after a free fall that lasted until the end of March 2020, we have seen a good recovery in all the size indices. The S&P BSE SmallCap has had a better recovery than the large- and mid-cap indices.

Exhibits 3 and 4 showcase returns for the 11 leading sector indices in India over the past six months.

From Exhibits 3 and 4, we can see that the S&P BSE Healthcare and S&P BSE Telecom posted strong six-month absolute returns of 21.61% and 17.33%, respectively. The S&P BSE Realty, S&P BSE Finance, and S&P BSE Industrials posted the lowest absolute returns of -30.50%, -29.38%, and -19.85, respectively, for the first half of 2020.

To summarize, we can say that the Indian capital markets fell sharply in the first quarter of 2020, especially in the month of March. However, there has been a recovery in the second quarter, although the six-month returns were still negative.

Over the past two decades, innovation in futures-based commodity indexing has allowed for the launch of commodity indices beyond broad market beta indices and into more sophisticated strategies with non-traditional roll mechanisms or contract selection.

In that vein, S&P Dow Jones Indices (S&P DJI) offers a wide variety of oil indices that offer exposure at different points along the crude oil futures curve, allowing market participants to select the index that best meets their investment requirements. For example, the S&P GSCI Crude Oil Dynamic Roll employs a flexible monthly futures contract rolling strategy and is designed to meet the demands of investors seeking to alleviate the negative impact of rolling during periods of contango.

Indices based on longer-dated contracts, such as the S&P GSCI Crude Oil 12 Month Forward, can also meet the needs of investors who prefer energy exposure with lower volatility or exposure that better reflects the long-term cost of oil production. Longer-dated indices can also be useful as a benchmark for real asset investments.

Oil indices based on multiple contracts are the newest offerings in commodity indexing. On June 15, 2020, S&P DJI launched the S&P GSCI Crude Oil Multiple Contract 55/30/15 1M/2M/3M. Instead of being represented by only one contract month, the index takes positions in three separate futures contract months. The S&P GSCI WTI crude oil contract production weights are distributed among the three contract months as follows: 55% is assigned to the contract month represented by the 1-month forward index, 30% is assigned to the contract month represented by the 2-month forward index, and 15% is assigned to the contract month represented by the 3-month forward index.

Multiple contract indices can add to or detract from index performance depending on the shape of the futures curve. During periods of contango, the indices benefit compared to the strategy that invests in rolling front-month futures contracts, but the reverse would take place during periods of backwardation. In light of the ongoing discussions among regulators, futures exchanges, and sponsors of financial products regarding position limits in commodity futures, financial products that are based on multiple contract indices may also find it easier to manage risk.

There are energy indices based on a broader range of petroleum products, ranging from Brent crude oil to oil products such as gasoline and heating oil. While crude oil product markets can be less liquid than crude oil, periods of deep structural contango generally occur less often in these markets, which may make indices based on these commodities more appealing to long-only investors with extended investment time horizons.

A broad range of energy indices exist today in the market, each tracking the performance of the oil market across different market segments and across the futures curve.

Where can environmental, social, and governance (ESG) benchmarks help investors and markets most? The answer may be in emerging markets, where it is crucially important to identify and navigate ESG concerns. The transparency that ESG benchmarks provide can help investors distinguish companies that prioritize the needs of not just their shareholders, but also their many additional stakeholders, including their employees, the communities they operate in, and the environment around them.

However, to truly drive change, an ESG index must be more than a flag to wave—it must set the foundation for investment. The S&P/BMV Total Mexico ESG Index, launched on June 22, 2020, is one such benchmark, built for investors looking for a tool to help them act.

The S&P/BMV Total Mexico ESG Index is built with the same philosophy underpinning the creation of many popular new ESG indices around the world, such as the S&P 500 ESG Index. The idea is that certain ESG indices should be more inclusive than exclusive to remain broad and diversified, such that the ESG index has a similar overall industry group weight as the benchmark, while providing an improved ESG profile.

Exhibit 1 shows how this index is constructed. First, exclusions are made according to companies’ involvement in business activities related to tobacco or controversial weapons or low compliance with the United Nations Global Compact (UNGC). Next, the S&P DJI ESG Score is used to screen and select companies. Finally, companies are weighted by their ESG Score.

The result is an index that, at launch, retained 29 of the 56 companies in its benchmark index, the S&P/BMV Total Mexico Index. By maintaining more than half of the original number of constituents and selecting companies within their industries, the index remains relatively balanced from a sector perspective. Exhibit 2 shows the average sector exposure of the ESG index and the benchmark index from the time S&P DJI had enough ESG data to calculate this index.

Because of the sector alignment and the ESG index constituents exhibiting an average beta of nearly 1—1.02 to be exact—the indices have historically performed largely in line with each other. This is attractive to many investors seeking to integrate ESG into their portfolios at a manageable level of risk.

In addition to this new index having achieved a similar risk/return profile as the market historically, market participants are also investing in better-performing companies from an ESG perspective—companies that align with their values. At launch, the composite ESG score for the S&P/BMV Total Mexico ESG Index was 59.6, a full 17 points higher than the composite score of its non-ESG benchmark index.

What does this higher score practically mean? It means more exposure to companies that have governance structures, human capital development, and environmental impacts better than their peers and in line with international standards, among many other positive qualifications. Further, it means that an investor using this index is aligning their investments with their values, thereby driving change in Mexico, creating a hopeful and sustainable future.

Volatility, dispersion, and correlation are elements of what we’ve elsewhere characterized as The Active Manager’s Conundrum. Active managers should prefer:

• Low volatility, which is typically associated with higher returns
• High dispersion, which means a larger payoff for correct stock selections
• High correlation, which reduces the opportunity cost of a concentrated portfolio

The conundrum arises because low volatility, high dispersion, and high correlation almost never occur at the same time.

An excellent example of this conundrum lies within the Kensho New Economy Indices. From our Q2 S&P Kensho New Economies Dashboard, Exhibit 1 illustrates that the Kensho sectors have much higher dispersion levels than the traditional S&P 500 GICS sectors. Interestingly, the Kensho sectors also have much lower correlations compared to their S&P 500 counterparts, unsurprisingly given the more idiosyncratic nature of their constituents compared to those within the GICS framework.

The results are even more striking in Exhibit 2, where we compare the S&P 500 GICS sectors to the Kensho subsectors, which have higher dispersion levels along with extremely low correlations.

Active managers, almost by definition, run less diversified, more volatile portfolios than their index counterparts. When correlations are high, the incremental volatility associated with being less diversified and more concentrated declines.  We define the cost of concentration as the ratio of the average volatility of the component assets to the volatility of a portfolio.  A higher cost of concentration implies a higher hurdle for active managers to overcome.

Applying this logic to the Kensho New Economies, we would expect the cost of concentration for the S&P Kensho New Economies Composite to be higher than that of the S&P 500, as its low correlations create the possibility of less incremental portfolio volatility. We observe this to be the case in Exhibit 3, which shows that this cost is consistently higher for Kensho through time.

This analysis has important implications for active management. Because of their high dispersion, there are immense opportunities for stock-pickers to add value by choosing among names in the Kensho New Economy Indices. But doing so requires active portfolios to bear a higher cost of concentration; the low correlation among the New Economies names means that stock-pickers forgo a huge diversification benefit.  Investors who choose active management couple the possibility of higher returns with the certainty of higher volatility.

On June 25, 2020, the German digital payment company Wirecard AG filed for insolvency following reports that over USD 2 billion in cash assets went missing. Wirecard’s stock has gone down 90% since the initial announcement, and the company’s lenders now face deep losses.

While the S&P ESG Index Series does not include Wirecard, the case sheds light on how governance factors are incorporated and controversies are monitored in screening companies included in many ESG indices and benchmarks.

The primary driver of constituent eligibility and selection into the S&P ESG Index Series is a company’s S&P DJI ESG Score, which is derived from the annual SAM Corporate Sustainability Assessment (CSA). The CSA is an industry-specific questionnaire based on financial materiality and is designed to source corporate sustainability information directly from companies and used to assign ESG scores. Insights gathered from the CSA form the backbone of the ESG score that is incorporated in the index constituent selection process.

In each S&P ESG Index, companies are removed from eligibility due to involvement in controversial weapons or tobacco (in line with specific revenue thresholds) or for having a low United Nations Global Compact score. In addition, companies with an S&P DJI ESG score in the bottom 25% by Global Industry Classification Standard® (GICS®) industry group on a global basis are also ineligible.[1] At the most recent annual rebalance, effective at the end of April 2020, Wirecard had an ESG score of 10 (out of a possible 100),[2] which is firmly within the range of excluded ESG scores. As a result, Wirecard was not eligible to be selected for any of the indices in the S&P ESG Index Series.

What stands out in Wirecard’s ESG score is its poor governance performance. The company received a score of 4 (out of 100) in the governance dimension in the most recent review cycle for the CSA. This low score is primarily driven by poor performance in the areas of privacy protection, risk and crisis management, and codes of business conduct. Given Wirecard’s recent public struggles, its already low governance score reflected this weakness.

Wirecard, in fact, has never been part of any S&P ESG Index. At each historical rebalance period dating back to 2018 (the first rebalancing when Wirecard was in a universe index for the S&P ESG Index Series), the company never broke the 25% score threshold for eligibility.

It is worth mentioning that in the vast majority of S&P DJI’s ESG benchmarks, including the S&P ESG Index Series, corporate controversies are monitored on an ongoing basis through a Media & Stakeholder Analysis (MSA).[3] When controversies occur between index rebalances, they are factored into the decision of whether or not a company’s ESG score should be reduced. An S&P DJI Index Committee, which oversees the index, assesses the revised ESG score to determine whether the company continues to meet the eligibility criteria and therefore should remain in or be removed from an index. Even though Wirecard was not in any S&P ESG Index and thus could not trigger this process, the S&P ESG Index Series does have measures in place to account for controversies affecting current constituents.

Wirecard’s struggles with governance are well documented by now. The financial-materiality-driven CSA framework was designed to identify a company’s sustainability performance from an ESG perspective. The combination of Wirecard’s ESG score plus the S&P ESG Index Series methodology appears to be fulfilling its intended design.

[1] For more information, please refer to the S&P ESG Index Series methodology.

[2] S&P DJI ESG Scores are designed to be read as percentiles; in the case of Wirecard, a score of 10 means that the company is in the bottom 10^th percentile globally within its industry.

[3] For more information on the MSA, please refer to the MSA Methodology Guidebook.