Indexology^® Blog

Despite the drop in volatility in many asset classes over the summer, some broke through key support and resistance levels.

The S&P GSCI Gold (TR) was one of them, reaching a new all-time high of USD 1,056.83 on Aug. 6, 2020, eclipsing the previous high from the summer of 2011. The underlying gold futures had reached new highs in several different major currencies over the past year, and they finally broke through in U.S. dollar terms.

Gold’s unprecedented rise is driven to a great extent by the bearish sentiment surrounding the U.S. dollar. Lower real rates and widespread fiscal and monetary stimulus measures have boosted demand for bullion, which is seen as a hedge against inflation and currency debasement. With many government bonds paying investors a negative return, the fact that gold is a financial asset that offers no income has become increasingly irrelevant.

Weakness in the U.S. dollar against a range of currencies is also supporting gold prices. The broad S&P U.S. Dollar Futures Index fell to a two-year low at the end of July 2020; in the eyes of some investors, gold is likely replacing the U.S. dollar as the ultimate safe currency. This break lower was a positive catalyst for gold to make new highs in the last week of July. Historically, there have been periods when the correlation between gold and the U.S. dollar was significantly negative. Current market conditions are ripe for the strength of negative correlation we are seeing in 2020 (see Exhibit 1).

Why is there such a strong negative correlation between gold and the U.S. dollar? The original use of gold was as a form of monetary exchange and store of value, just as the U.S. dollar is used today. The complementary nature of the two create an environment in which market participants tend to move from one to the other. When the U.S. dollar decreases, market participants look to other asset classes as alternative stores of value. Given that gold and most commodities are denominated in U.S. dollars, any depreciation in the dollar, by definition, increases the purchasing power of other currencies, potentially increasing the demand for commodities in those regions.

Faced with both an unprecedented shock and policy response, it remains unclear how inflationary the economic recovery will be, but inflation has certainly returned to the vocabulary of some investors. Gold is an inflation-sensitive asset. Inflation protection is a typical reason people look to commodities, and gold, to hedge their exposure. Over the long term, gold does not always move with inflation, but the two tend to be positively correlated (see Exhibit 2). Gold tends to be a better hedge than crude oil, especially during times of unexpected inflation. Over the past 40 years, the S&P GSCI Gold had a positively correlated performance to the U.S. CPI. Late business cycle environments tend to be a time for gold to shine—possibly more so than times of high inflation.

For more insight on gold, check out our previous blog that highlights why now is Gold’s Time to Shine. S&P DJI also released the first Spotlight on Commodities newsletter, containing relevant content for market participants looking to understand the performance of commodities this year.

Many advisors feel that their favorite active manager will guide them through market volatility and limit drawdowns during times of market stress. But is that how things played out at the beginning of 2020? S&P DJI’s Brent Kopp and Berlinda Liu take a closer look at COVID-19’s impact on active vs. passive performance.

In our paper, How Smart Beta Strategies Work in the Australian Market, our studies indicated that most factor indices in Australia exhibited distinct return characteristics during up and down markets. Indeed, different factor indices also displayed unique style and industry factor exposures, resulting in factor index performance differentials over the long term. In this blog, we examined the risk factor exposures, active risk, and excess return attribution for various S&P DJI Australian Factor Indices from Dec. 31, 2004, to May 29, 2020.

According to the factor exposure and return attribution table in Exhibit 1, the S&P/ASX 200 Momentum, S&P/ASX 200 Quality, and S&P/ASX 200 Low Volatility delivered better performance among various factor indices, mainly due to the high cumulative returns of their target style factors (momentum, profitability, and low volatility, respectively). All S&P DJI Australian Factor Indices had high exposures to their target style factors relative to the S&P/ASX 200, but unintended style factor exposures, industry biases, and stock-specific risk were also observed in various indices, and some of them had significant impacts on their excess returns. Return contribution from style factors was dominant for the S&P/ASX 200 Momentum and S&P/ASX 200 Quality, while the impact of stock-specific risks was pronounced in the S&P/ASX Small Ordinaries, S&P/ASX 200 Enhanced Value, and S&P/ASX Dividend Opportunities Index.

The S&P/ASX 200 Momentum attributed most of its outperformance to its target exposure to the momentum factor, while the impact of industry bias and stock-specific risk were minor. The outperformance of the S&P/ASX 200 Quality was mainly attributed to its target exposure to profitability and favorable industry biases, while its unintended tilts to small cap and momentum also attributed positively. Return attribution from the unexplained stock-specific risks was relatively insignificant.

The small-cap exposure attributed positively to the returns of the S&P/ASX Small Ordinaries, but the unintended exposures to high volatility, growth, and low profitability resulted in a significant negative return impact. Meanwhile, the target factors for the S&P/ASX 200 Enhanced Value and S&P/ASX Dividend Opportunities Index contributed negatively during the examined period, and the active exposures to low momentum and high volatility largely eroded the performance of these two indices. We also noticed that industry exposures and stock-specific risks posed significant negative impacts for the S&P Small Ordinaries, S&P/ASX 200 Enhanced Value, and S&P/ASX Dividend Opportunities Index.

For the S&P/ASX 200 Low Volatility, the target exposure was largely displayed as low market sensitivity (i.e., low beta), which generated significant excess returns for the index. Its small-cap bias also contributed positively, while its tilts to low momentum and high dividend yield, as well as unfavorable industry exposures, had a negative return impact. Different from what we saw from other Australian factor indices, stock-specific risk contributed favorably to the S&P/ASX 200 Low Volatility.

To understand the main sources of portfolio risks of the various factor indices, we decomposed the active risks of the S&P DJI Australian Factor Indices into different style risk factors, industry factors, and stock-specific risks. As shown in Exhibit 2, the risk composition was unique for different factor indices, and changed over time. Total risk attribution from style factors varied across a wide range for factor indices, from an average of 69.8% for the S&P/ASX Small Ordinaries to 30.5% and 27.2% for the S&P/ASX 200 Quality and S&P/ASX Dividend Opportunities Index, while total style factors accounted for 45.8%, 39.7%, and 38.7% of active risk for the S&P/ASX 200 Low Volatility, S&P/ASX 200 Momentum, and S&P/ASX 200 Enhanced Value, respectively.

Target style factors were key risk contributors for most factor indices, mainly due to high active exposures to the target factors. However, risks associated with unintended style factors, industry factors, and stock-specific risk were pronounced in some indices. For instance, the small-cap factor constituted a significant portion of active risk in most of the S&P DJI Australian Factor Indices over this period. On the other hand, industry factor risks were significant in the S&P/ASX 200 Low Volatility, S&P/ASX 200 Quality, and S&P/ASX Dividend Opportunities Index, accounting for 39.3%, 34.0%, and 30.4%, on average, of their total active risks, while stock-specific risks attributed to 42.3%, 36.7%, and 35.5% of the total active risks in the S&P/ASX Dividend Opportunities Index, S&P/ASX 200 Value, and S&P/ASX 200 Quality, respectively.

As we can see from this risk/return attribution analysis, various factor portfolios had distinct factor exposures that drove performance differently. Decomposing the source of active returns and risks helps explain the behavior of factor portfolios in different market environments, especially for those with high risk/return attributions from unintended style factors and industry factors.

Why choose index investing? Yes, the merits of diversification and low cost are usually factored in, though one critical benefit that many do not realize is the transparency that is provided in the methodology of an independent index provider. To understand what goes into the design and methodology of an index, it’s important to note that it’s not a random pick of securities to represent the index’s concept or design. So, let’s skim through some basics of index construction.

Indices offer a wide range of options whereby their calculation methods might vary. Most equity indices are market-cap weighted and float adjusted, where each stock’s weight in the index is proportional to its float-adjusted market value. Some equity indices are price-weighted indices, in which constituent weights are determined solely by the prices of the constituent stocks in the index. An example would be the Dow Jones Industrial Average®. Then there are equal-weighted indices in which each stock is weighted equally in the index. There can be restrictions placed in the index where certain constituents are assigned a minimum or maximum weight, and this can be applied to sectors as well. A few more to add to the variety are options include leveraged and inverse indices, which return positive or negative multiples of their respective underlying indices, dividend indices, which track the total dividend payments of index constituents, and the list goes on.

A common query among many is how exactly is an index calculated? Is it a simple average, or is there some complex formula that runs that magic number? The key concept to understand index calculation would be the index divisor. In a capitalization-weighted index, wherein the portfolio consists of all available shares of the stocks in the index, the total value will be a large number (e.g., the float-adjusted market value for the S&P 500® is a figure in the trillions of U.S. dollars). Hence, to make it easy, the number is scaled down by dividing the portfolio market value by a factor, usually called the divisor.

An index does not behave like a portfolio, as a stock that is added to or deleted from an index would not result in the index level changing, in contrast to a portfolio’s value that would usually change to reflect movements in its holdings. To ensure that the index’s value, or level, does not change when stocks are added or deleted, the divisor is adjusted to offset the change in the market value of the index. Thus, the divisor plays a critical role in the index’s ability to provide a continuous measure of market valuation when faced with changes to the stocks included in the index. In a similar manner, some corporate actions that cause changes in the market value of the stocks in an index should not be reflected in the index level. Adjustments are made to the divisor to eliminate the impact of these corporate actions. There is a large range of different corporate actions, from routine share issuances or buybacks to less-frequent events such as spin-offs or mergers. The index provider details the impact of such corporate actions in their methodology document. The application of changes depends on the type of index and the need for the adjustment with respect to the announced corporate action.

Furthermore, index providers list the rebalancing schedule of the index so that the index is consistent with the methodology.

Index providers do not create the passive products, and hence there is complete independence and a lack of bias to the passive product offered by a product provider. For the product provider as well, they can impress upon the neutrality of the product, as the underlying design is based upon the index provider’s methodology.

Exhibits 1 and 2 provide a sample of different index types and their trends.

S&P Dow Jones Indices (S&P DJI) and BMV recently launched the long-awaited S&P/BMV Total Mexico ESG Index to great fanfare. The Mexican equities market is in the early stages of exploring ESG-related concepts, from sustainable assessments at the issuers’ level to sustainable investments for asset owners, asset managers, and regulators. The S&P/BMV Total Mexico ESG Index, which uses the world-renowned Corporate Sustainability Assessment (CSA) from SAM (part of S&P Global), is a local index that employs the latest international standards and best practices.

The following statistics aim to highlight the main characteristics of the S&P/BMV Total Mexico ESG Index:

• The index currently includes 29 constituents, but this amount can change during its annual rebalancing. Of these constituents, 23 are also in the S&P/BMV IPC. One of the main differences with the S&P/BMV IPC is that the S&P/BMV Total Mexico ESG Index includes FIBRAS (REITs) in order to recognize these companies from an ESG perspective;
• As of July 20, 2020, the S&P/BMV Total Mexico ESG Index represented 68% of the market cap of the S&P/BMV IPC;
• The weight of the largest constituent was 6.9% as of July 20, 2020, while the largest company in the S&P/BMV IPC was nearly 16% of the index;
• The S&P/BMV Total Mexico ESG Index has an ESG profile that is 17 points higher than its benchmark index, the S&P/BMV Total Mexico Index. This represents a maximum potential increase in its ESG profile of 43% over the benchmark;
• Looking at sector diversification, we find that nine GICS^® sectors are represented in the index (see Exhibit 1).

How many of the constituents in the S&P/BMV Total Mexico ESG Index are included in the other S&P ESG Indices? Let’s see: 15 constituents of the S&P/BMV Total Mexico ESG Index are also constituents of the Dow Jones Sustainability MILA Pacific Alliance Index (55 constituents)—this is noteworthy considering that the methodology of each index is different per the following:

• The Dow Jones Sustainability MILA Pacific Alliance Index is a best-in-class methodology in which the top 30% per industry are selected; while
• The S&P/BMV Total Mexico ESG Index seeks to be aligned with the principal sustainability criteria. The index applies exclusions based on certain business activities and non-compliance with the UN Global Compact criteria. It is weighted by S&P DJI ESG score.

In addition, three companies in the S&P/BMV Total Mexico ESG Index are also members of the Dow Jones Sustainability Emerging Markets Index, which has 97 constituents in total.

Finally, it is important to mention that of the 29 index constituents, 26 completed the SAM CSA, while for the remaining three constituents, SAM performed the evaluation using their public information.

Considering these points, we see the S&P /BMV Total Mexico ESG Index complies with the characteristics of liquidity, representation, replicability, and diversification, which could allow it to be used as benchmark or in financial products such as ETNs.

I would like to acknowledge Silvia Kitchener for her contribution to this blog.