Indexology^® Blog

The year 2020 has been unique, with the COVID-19 pandemic bringing unprecedented changes to economic activity that no one was fully prepared for, as well as record levels of volatility in financial markets. But such disruption not only creates innovation, it also gives opportunities to contrarian options and allows new themes to emerge dominant.

India has always been a country with a “home bias” in its investment strategies—meaning that Indian investors have generally preferred local securities to global. This is understandable; high yields in the fixed income markets and strong performance from equities, as well as a faith that India would deliver world-beating economic growth, kept investors glued to the local markets. However, the market’s reaction to the events of 2020 have provided a counterpoint to the accepted wisdom, when opportunities beyond domestic borders emerged as the clear winners.

Exhibit 1 compares the YTD trends in the S&P BSE SENSEX with a range of global indices calculated by S&P DJI, including our benchmarks for the U.S., Europe, and China. As the chart makes clear, 2020 has been a year in which global diversification could have helped Indian investors. Note that the S&P BSE DOLLEX 30 is the U.S. dollar equivalent of the Indian rupee-denominated S&P BSE SENSEX; for purposes of comparison, the performance of all indices is shown in U.S. dollars.

Whenever we compare performance, analyzing different time periods helps understand how the trends played out for a particular investment strategy or rather, in this case, the indices representing the country markets. The case for international diversification for Indian investors also holds up well in the long term, particularly for the world’s largest stock market: the S&P 500’s performance, whether over 1, 3, 5, or 10 years, was distinctly superior.

The global opportunity set offers a wide range of sectors and companies—within them, the likes of Microsoft, Apple, Amazon, and Facebook, that have benefited from the move toward virtual workplaces, virtual shopping, and higher spending on communications and technology. Using the S&P Global BMI, Exhibit 3 highlights the performance of certain global equity sectors and industries that showed both substantial gains and declines this year, illustrating the strength of the market’s trends. While airlines and energy companies have seen steep declines across the world, the soaring shares of global software, IT, and internet companies have offered refuge to those who had made an allocation.

International diversification provides local investors the chance to take part in such global trends and participate in the opportunities that arise from advancing technology and global changes in corporate and consumer behavior. Furthermore, in times of turmoil, broader diversification could enable market participants to weather the bad times, along with making the most of the good times.

The extraordinary events of 2020 have so far emphasized the potential of global equities to Indian investors, but are they seeing the opportunity? Offering perspective, S&P Dow Jones Indices’ series of global benchmarks can help frame the landscape of international investing.

Note: Thanks to Tim Edwards for a series of conversations that generated ideas for this blog and for providing some of the accompanying data.

Growth style investing has outperformed value for over a decade but its relative returns against value so far in 2020 have been unprecedented: the S&P 500^® Growth index boasts its highest-ever year-to-date relative returns (+32%) versus its value counterpart through the third quarter. This comes despite growth’s eight-month winning streak coming to an end in September.

Amid declining interest rates earlier this year and growth companies’ higher sensitivities to discount factors, it is perhaps unsurprising that growth’s year-to-date relative returns have been driven by the outperformance of the most growth-like names in the market. Indeed, the total index market capitalization of “pure growth” S&P 500 companies—those with a growth exposure score of one, meaning they have 100% of their free-float market capitalization allocated to the S&P 500 Growth index—rose by nearly USD 3 trillion in the first three quarters of 2020. This increase was larger than the United Kingdom’s USD 2.2 trillion index market capitalization in the S&P Global BMI at the end of September.

In comparison, the collective index market capitalization of “pure value” companies dropped by USD 1.64 trillion since the end of 2019, and there were declines of USD 0.09 trillion for “middle” companies – those whose capitalization is distributed between the S&P 500 Growth and Value indices.

Much has been written recently about the outperformance of the largest names in the market in 2020, prompting concentration concerns by some market participants. Exhibit 3 shows that the five largest companies in the S&P 500 currently account for around 23% of the index, similar to the levels observed in the 1970s and up from 17% at the end of 2019.

Given that all five of the largest names in the S&P 500 are classified as “pure growth” companies, their outperformance also led to higher concentration in the S&P 500 Growth index. Exhibit 4 shows that the Herfindahl- Hirschman Index (HHI) for the growth index reached an all-time high at the end of August, with the five largest names in the index accounting for nearly 39% of the index.  In contrast, the HHI measure for the value index hit an all-time low earlier this year.

For active managers looking to deliver excess returns over the benchmark, elevated index concentrations means having (correct) views over the fortunes of the largest index constituents—and changing allocations accordingly—is more valuable. Results from our Mid-Year 2020 U.S. SPIVA^® Scorecard suggest that many active managers correctly identified this year’s growth trends and over-weighted the largest, most growth-like companies in the market: 75% of U.S. large-cap growth equity funds beat the S&P 500 Growth Index over the 12-month period ending June 30, 2020.

In contrast, over 70% of large-cap value managers underperformed the S&P 500 Value index over the same horizon.  Much lower levels of index concentration and the more varied reactions of the value index’s constituents amid the “COVID correction” appeared to make it more difficult to identify trends in value.

As a result, the outperformance of the largest, most growth-like names in the market has propelled growth to its record-breaking relative returns compared to value, and appeared to help many growth managers to outperform recently. However, SPIVA results show how difficult it has been for active managers to outperform across the size and style spectrum, especially over longer horizons, and our Fleeting Alpha report shows that past (out)performance is no guarantee of future results. In other words, it is worth remembering that the index advantage is not a coincidence.

We recently issued our mid-year SPIVA^® reports for the U.S., Australia, and Europe, and other regions will follow in due course. Although one can sometimes find exceptions in the short run, the long-term results of SPIVA can be easily summarized:

• The majority of active managers underperform most of the time.
• Historical success does not predict future success.

SPIVA continues a line of inquiry that began nearly 90 years ago with the first study of active fund performance versus passive benchmarks. This work accelerated in the 1970s, as the growth of professional portfolio management drew increasing academic interest. Nobel laureate Paul Samuelson was representative of his contemporaries in suggesting that “most portfolio decision makers should go out of business.”

Active managers didn’t take kindly to Samuelson’s suggestion in 1974 and, despite the accumulation of confirming evidence since then, they don’t take kindly to it today either. We’ve estimated that the cumulative cost savings to asset owners just from indexing the S&P 500^®, S&P MidCap 400^®, and S&P SmallCap 600^® amount to better than $300 billion, and every dollar of costs saved by the investor is a dollar of fees not paid to an active manager. So while resentment is to be expected, it’s surprising that critics of SPIVA sometimes focus on its minutiae, rather than on its results.

The most important thing to realize about SPIVA results is that they are not a coincidence. The active management community didn’t lose a cosmic coin flip 90 years ago; active underperformance happens for a set of readily identifiable reasons. These include:

Professionalization. Portfolio management is a zero-sum game; the only source of alpha for the winners is the negative alpha of the losers. When most of the assets in a market are professionally managed, the average professional won’t beat the market because the average professional is the market. It’s not a coincidence that the first index funds were launched in the 1970s; by that point the U.S. equity market had been largely professionalized.

Cost. The expense ratio of the average actively-managed equity mutual fund was 0.74% in 2019; the average index fund cost 0.07%. The average active manager therefore starts out 67 bps in the hole.

Skewness. The distribution of stock returns is skewed—i.e., most stocks underperform the market average. Exhibit 1 illustrates this for the S&P 500.

Of the 1,010 stocks that were part of the S&P 500 between 2000 and 2019, only 267 returned more than average. The probability that a randomly chosen stock would deliver above-average performance, in other words, was 26%, not 50%. When fewer stocks outperform, active management is harder.

These (and other!) reasons are robust and sustainable. Investment management will stay professionalized, active costs will always exceed index costs, and in most years most stocks underperform the average in most markets. The index advantage is likely to persist.

What’s driving demand for gold this year? S&P DJI’s Jim Wiederhold and CME Group’s Blu Putnam explore what’s pushing gold prices up and how investors are putting the precious metal to work in portfolios.

On Sept. 4, 2020, S&P DJI’s U.S. Index Committee announced that Etsy, Teradyne, and Catalent were being added to the S&P 500^®, replacing H&R Block, Coty, and Kohl’s.

The changes attracted significant market attention and sparked a discussion around the names being added to the index, as well as those that were not. These updates also coincided with the S&P 500’s scheduled quarterly rebalancing. Changes to the index can be made at any time—they do not have to happen during quarterly rebalances. However, given the higher-than-usual attention, it’s worth revisiting the S&P 500’s purpose and objective, what the Index Committee does, and how the committee helps ensure that the index is doing its job.

What Is the S&P 500’s Objective?

The S&P 500 is synonymous with U.S. equity market performance and is referenced by investors, analysts, and the media every day. The index was up 1.5% today? Great, the S&P 500 is doing well! Did the market decline? Uh-oh, the S&P 500 did poorly. But whether the index is “doing a good job” has little to do with the direction of its returns.

Per the S&P U.S. Indices Methodology, the objective of the S&P 500 is to “measure the performance of the large-cap segment of the U.S. market.” That’s it. The job of the Index Committee is not to add stocks that it thinks will perform well. Instead, it makes sure the index continues to provide a representative reflection of the large cap U.S. equity market.

Rebalancing versus Reconstituting

The U.S. large-cap market has changed significantly over the years and there are several ways the Index Committee ensures that the 63-year-old S&P 500 reflects that evolution. One of them is by rebalancing the index.

During a rebalance, S&P 500 constituents’ individual weights are adjusted to reflect their latest share counts and float. Company share counts are constantly changing as they issue stock and perform buybacks, so the S&P 500 is rebalanced every quarter to adjust each company’s weighting based on its latest share count and float.
While the Index Committee can also reconstitute the index during a rebalance by adding or removing companies, these changes to index membership can be made at any time—they don’t have to happen during a rebalance and a rebalance doesn’t have to include a reconstitution.

Since the beginning of 2017, 82 companies have been added to the S&P 500.

So, Is the S&P 500 Doing Its Job?

This brings us back to our first question. Have all the changes made over the years by the Index Committee helped the index accurately represent the U.S. large-cap market?

One way we can grade the S&P 500’s performance is through sector representation. Since the index has a fixed count of 500 companies, not every eligible company can be added to the index. One of the factors the Index Committee looks at when considering changes to the index is sector composition. Per the index methodology, this is measured by a comparison of GICS^® sector weights in the S&P 500 with the corresponding weights in the large-cap range of the S&P Total Market Index (TMI), which measures the performance of all U.S. stocks.

Using the historical market capitalization thresholds from Appendix A of the S&P U.S. Indices Methodology document, we can arrive at the GICS sector weights for the large-cap section of the S&P TMI.

Exhibit 2 shows the relative sector weights of the S&P 500 against the large-cap portion of the S&P TMI. The average difference is based on year-end weights between 2007 and 2020.Clearly, the S&P 500 GICS sector weights have typically been similar to the large-cap portion of the S&P TMI. And while some differences have emerged in 2020, the S&P 500 remains representative of the large-cap U.S. equity space. The index is doing its job.