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Measuring Innovation: Essential Insights in an Era of Disruption to the Global Economy

Why Cap Weighting?

Risk-Adjusted SPIVA®: No More Excuses?

Building a Sustainable Core with the S&P 500 ESG Index

Is Canada Inadvertently Excluded from Your International Equity Allocation?

Measuring Innovation: Essential Insights in an Era of Disruption to the Global Economy

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John van Moyland

Managing Director, S&P Global Head of S&P Kensho Indices

S&P Dow Jones Indices

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Introducing the S&P Kensho Moonshots Index – Next-Generation Innovators

Innovation risk ranks as one of the most significant existential threats faced by companies today. The Fourth Industrial Revolution, and the attendant widespread disruption to the global economy, has significantly amplified an already established trend: accelerating change and the ever-decreasing lifespans of companies, or what the economist Joseph Schumpeter aptly described as ”creative destruction.” To wit, according to Innosight, the average tenure of a company in the S&P 500® is forecast to be just 12 years in 2027, down from 24 years in 2016—many companies are simply unable, or unwilling, to adapt fast enough to stay ahead of the curve.

Given this backdrop of exponential innovation and disruption, it has become more essential than ever for market participants to adopt a quantifiable framework with which to understand and measure innovation—not just in terms of identifying next-generation products and services and the companies producing them (for these, please review the S&P Kensho New Economies), but also to assess a company’s propensity for innovation. This may be considered from three perspectives:

  1. How “innovation-oriented” the company’s mission and culture are;
  2. How many resources the company is allocating to innovation; and,
  3. How successful the company is in executing its innovation strategy.

Using a rules-based, proprietary framework, we have developed innovation factors that quantify each of these elements, providing market participants with a unique and critical tool for navigating the rapidly changing corporate and technological landscape.

The S&P Kensho Moonshots Index is the first in a series of indices to leverage these novel innovation factors. This index seeks to capture the most innovative companies that are still relatively early in their gestation. It consists of the 50 U.S.-listed companies with the highest Early-Stage Innovation Score that produce next-generation products and services. The Early-Stage Innovation Score1 is the product of innovation factors 1 and 2 listed above and provides a quantitative measure for a company’s commitment to innovation, notwithstanding that it may be early in its lifecycle and still in the process of developing its product portfolio. Large companies are also screened out, emphasizing the focus on emerging innovators.

The performance characteristics of the S&P Kensho Moonshots Index (see Exhibit 1), and its relative outperformance, reflect the dynamic nature of its constituents; it is consistent with the higher risk/return profile typically expected, but rarely seen, in private equity or hedge funds.

Exhibit 2 illustrates the consistency of outperformance over the past five years, another quality rarely found in either active or private equity or hedge funds.

By construction, the S&P Kensho Moonshots Index excludes the mega-cap tech names, instead focusing on the next generation of innovators (90% of constituents have a market capitalization of less than USD 10 billion); it is also equal weighted, limiting concentration risk. While the mega-cap tech companies are often considered the bellwethers of innovation, it is instructive to note that 36% of constituents of the S&P Kensho Moonshots Index outperformed the average returns of the FAANGs since the market bottom on March 23, 2020 (see Exhibit 3).

In part 2 of this blog, we will explore the S&P Kensho Moonshots Index’s focus on smaller companies, how effective it is at identifying those ground-breaking companies, and what happens to them once they leave the index.

The author would like to thank Adam Gould, Senior Director, Research and Quantitative Strategist, S&P Global for his contribution to this blog.

1 To learn more about the Early-Stage Innovation Score, please visit the S&P Kensho Moonshots Index Methodology.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Why Cap Weighting?

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Craig Lazzara

Managing Director and Global Head of Index Investment Strategy

S&P Dow Jones Indices

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Journalists and others occasionally offer comparisons of capitalization-weighted index funds with other weighting schemes. Some of these efforts are more useful than others, but none, in my experience, identify the question that cap-weighted indices were initially designed to answer, and which accounts for their enduring economic significance. That question is, simply put: What is the total value of the stock market?

If we want to compute the total value of any stock market, the procedure is simple: for each company in the market, multiply shares outstanding by price, and add up the individual results. We can make the calculation as often as we like (or as often as our computational powers permit). By comparing values at two different periods, we can derive the market’s return; dividing Tuesday’s market value by Monday’s market value tells us Tuesday’s return. This is mathematically equivalent to multiplying each individual stock’s return by its beginning weight. In other words, the percentage return of a capitalization-weighted index tells us the percentage change in the aggregate value of all the stocks in the index.

No other weighting scheme produces this result. The percentage return of an equally weighted index, for example, tells us the return of the average stock, but not the change in the value of the entire stock market. Factor and thematic indices likewise have many uses, but are not particularly useful in telling us anything about the value of the entire market. Capitalization-weighted indices thus have a unique importance for economists; the S&P 500®, for example, is a leading indicator of the performance of the U.S. economy.

None of this discussion has anything to do with index funds, and of course indices were used for economic analysis long before they became the basis for financial products. Serendipitously, several attributes of capitalization-weighted indices make them particularly useful as the basis for index funds. The most important of these is that cap-weighted index funds are relatively easy (and cheap) to maintain. Unless the underlying index changes, a properly constructed cap-weighted index fund is not required to trade. Changes in the value of index components are exactly reflected in the value of the fund. Other popular weighting schemes (e.g., equal weighting or factor weighting) inherently require more turnover.

In part because cap-weighted indices don’t require much trading, in part because they can represent an entire economy rather than simply one aspect of it, and in part because we can’t all be above average, cap-weighted indices also continue to be demonstrably hard to beat. The popularity of capitalization-weighted indices is not arbitrary or inexplicable. We live in a capitalization-weighted world, and cap-weighted indices are a reflection of that reality.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Risk-Adjusted SPIVA®: No More Excuses?

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Alberto Allegrucci

Senior Research Analyst, Global Research & Design

S&P Dow Jones Indices

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For the first time, the SPIVA Europe Mid-Year 2020 Scorecard introduced risk-adjusted performance evaluations of European equity funds. Previously, proponents of active fund management may have criticized the SPIVA scorecard for measuring performance on a return-only basis. They may have argued that this only told one side of the story, and that their abilities should also have been judged on the level of risk that they employed. After all, given funds with similar returns, would investors not prefer the fund with lower risk? A similar question could arise when comparing active funds with their benchmarks. Do benchmarks perform better simply because they take on more risk? Adjusting returns by the risk involved allows us to tell the whole story and more closely compare how well active funds and their benchmarks performed per unit of risk taken.

Do European Benchmarks Still Perform Well on a Risk-Adjusted Basis?

In our latest SPIVA Europe Scorecard, a fund or benchmark’s risk-adjusted return was computed as the annualized average monthly return divided by annualized standard deviation of the monthly return for the period observed. The intuition is straightforward: rather than looking at absolute returns, we looked at the returns attained per unit of risk borne by the investor. Exhibit 1 shows the percentage of European equity funds outperformed by their benchmark and compares the metrics computed using different measures of performance. The percentage of funds that outperformed the benchmark was largely unaffected by adjusting the performance by its risk, and the notion that active funds may yield lower returns because they were less risky did not seem to be confirmed by the data. Otherwise, once adjusted for risk, we should have seen a much lower percentage of active funds being outperformed by their benchmark across the different time periods. Instead, we saw similar numbers, which increased steadily when looking at the medium to long term. This highlights a stylized fact already well substantiated by our SPIVA scorecards: in the long run, the majority of active funds failed to beat the benchmark.

The U.K. Case

Exhibit 2 shows the results of carrying out the same exercise for U.K.-focused equity funds. In the short term, active funds performed better on a risk-adjusted basis: only 12% were outperformed by the benchmark on a risk-adjusted basis, compared with 32% when looking at absolute returns. However, when looking at longer periods, the same pattern as was seen in Europe emerged. Not only did it seem harder for active funds to beat their benchmark in absolute performance terms, but their risk-adjusted performance could not keep up either. Across the 10-year period, the relationship seen in the short term was inverted; on a risk-adjusted basis, a larger percentage of active funds were outperformed by the benchmark compared to an absolute return basis.

Our SPIVA Europe Mid-Year 2020 Scorecard also shows risk-adjusted performance metrics for other European fund categories. In most cases, the conclusion was similar: risk adjustment did not seem to save active funds from being outperformed by their benchmarks. With this new addition to the SPIVA Europe Scorecard, it begs the question, “Are there any more excuses left for active managers?”

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Building a Sustainable Core with the S&P 500 ESG Index

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As demand for ESG continues to grow, how is the S&P 500 ESG Index helping investors reinforce core allocations and align objectives with ESG values? S&P DJI’s Maggie Dorn and State Street Global Advisors’ Brie Williams take a closer look at the potential benefits of putting this index to work in purpose-built portfolios.

Learn more: https://www.spglobal.com/spdji/en/education/article/the-sp-500-esg-index-defining-the-sustainable-core/

 

 

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Is Canada Inadvertently Excluded from Your International Equity Allocation?

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Michael Orzano

Senior Director, Global Equity Indices

S&P Dow Jones Indices

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For a U.S. investor, developed market exposure outside of the U.S. is a core building block in forming a comprehensive global portfolio. In part because of its status as the world’s first international equity index, MSCI EAFE enjoys a commanding market presence for international equity benchmarks. It also serves as the underlying index for many of the largest international equity ETFs and index funds. However, what many don’t realize is that MSCI EAFE excludes Canadian securities entirely, which may create an unintended gap in exposure or reflect an unfair performance benchmark for a manager focused on developed ex-U.S. equities.

In our third blog in a series highlighting key features of the global equity benchmark landscape, we explore the limitations of choosing MSCI EAFE as a regional representation of the international equities asset class.

Exhibit 1 depicts the country composition of MSCI EAFE compared to the S&P Developed ex-U.S. BMI, which includes all developed markets excluding the U.S. With an 8.4% weight, Canada was the third largest market out of the 24 countries included in the S&P Developed ex-US BMI as of Sept. 30, 2020.

Without a separate, standalone allocation to Canada, a global equity portfolio based on the S&P 500®, MSCI EAFE, and an emerging markets equity index would exclude Canada, the world’s fifth largest equity market, entirely.

When evaluating international equity index exposures, it is critical to fully understand the underlying benchmark being tracked to ensure it is covering all countries you expect it to include. Similarly, an actively managed fund should not be benchmarked to an index that excludes Canada if its mandate is to invest in all developed markets excluding the U.S. Remember to look under the hood or you might be inadvertently excluding major countries from your global equity opportunity set.

To learn more about the comprehensive coverage of the S&P Global BMI Index Series, see The S&P Global BMI: Providing Consistent Insights into Global Equity Markets since 1989.

The posts on this blog are opinions, not advice. Please read our Disclaimers.