Indexology^® Blog

The headline S&P GSCI rose 4.9% in January, as the industrial portion of the global economy continued to bounce back from the first wave of the COVID-19 pandemic and lockdowns in 2020, and the prices of many agricultural commodities spiked higher on the back of record demand from Asia and the growing risk of grain export restrictions.

The petroleum complex sustained its impressive recovery in January. The S&P GSCI Petroleum rallied 7.3% for the month. While there has been some moderation to the pace of the demand rebound due to a slower start to COVID-19 vaccinations in many regions and the cautious pace of reopening, the oil market remained tight, with Saudi Arabia pledging additional, voluntary production cuts and other OPEC+ producers holding production steady. Policy shifts in the U.S. are also expected to temper long-term oil supply prospects.

After a strong 2020 for the S&P GSCI Industrial Metals, performance in January was a paltry 0.4%. Heavyweights Aluminum and Copper were little changed, while the S&P GSCI Nickel rose 6.4% and the S&P GSCI Zinc fell by almost the same amount. Demand for nickel use in electric vehicles was front of mind for market participants, while zinc fell due to an unexpected surge in stock to a three-year high in the London Metal Exchange warehouses.

The S&P GSCI Gold fell 2.6% in January after a stellar 2020, when it posted an all-time high. Consolidation has been a trend for the yellow metal over the past few months. The S&P GSCI Silver rebounded on the last day of the month by almost 4% to post a monthly gain of 1.9%. With the intensified push toward green technology, silver demand for solar and electric vehicles provided the impotence for price appreciation while the “poor man’s gold” also attracted the attention of Reddit retail investors. The S&P GSCI Palladium fell 10.0% in January after a 4.9% fall on the last day of the month. Palladium has been riding high over the past five years with the global shift to lower carbon emitting autos and booming demand. Palladium is used in the catalytic convertors for gasoline powered autos.

The S&P GSCI Corn ended the month up an impressive 13.0%. On the last day of the month, the USDA confirmed that China booked 2.1 million metric tons of U.S. corn, the largest-ever single sale to the Asian country. That brought China’s four-day buying total to 5.85 million metric tons, more corn than the U.S. has ever shipped to China in an entire marketing year. Across the rest of the agriculture complex, only the S&P GSCI Coffee and S&P GSCI Cocoa finished the month in negative territory.

It was a quiet start to the year for livestock. The S&P GSCI Livestock rose 0.9%, with lean hogs and live cattle prices both benefiting from the rally in the grains market.

What’s the material impact of the ESG data and scores on index construction and risk/return? Join S&P DJI’s Jaspreet Duhra, UBS Asset Management’s Andrew Walsh, and S&P Global’s Manjit Jus as they discuss the increasingly important role of market-leading ESG assessments.

Watch Now: https://www.spglobal.com/spdji/en/index-tv/article/how-deeper-data-impacts-esg-investing/

2020 witnessed outperformance from some of the largest S&P 500^® companies as investors expected these firms to be better placed to navigate the COVID-19 environment. Exhibit 1 shows that this outperformance led to the largest names accounting for an unusually high proportion of the U.S. large-cap equity benchmark, and therefore having a bigger impact on the index’s returns. For investors looking to gain large-cap exposure with lower sensitivity to the biggest names, and potentially to take advantage of reductions in market concentration, Equal Weight may be worth considering.

Launched in January 2003, the S&P 500 Equal Weight Index weights each S&P 500 company equally at each quarterly rebalance. Exhibit 2 shows the historical benefit from applying this weighting scheme within U.S. large caps; the S&P 500 Equal Weight outperformed since its launch as well as over its lengthier, back-tested history. Rather than being strictly a U.S. phenomenon, the outperformance in Equal Weight indices has been observed globally, including in Japan.

One of the key perspectives in explaining equal weight indices’ returns is their smaller size exposure: for example, over 50% of the historical variation in the S&P 500 Equal Weight Index’s relative returns is explained by size.  This exposure occurs because, as Exhibit 3 illustrates, the distribution of weights within equal weight indices is far more even than within their market-cap weighted parents. For example, the S&P 500 Equal Weight Index is far less sensitive to the performance of the largest names in the market and offers more exposure to smaller S&P 500 companies.

Equal weight’s smaller size exposure helps to explain the link between market concentration and equal weight’s relative returns. All else equal, if the largest companies (to which equal weight has less sensitivity) outperform, concentration rises, and equal weight is likely to underperform its cap-weighted benchmark. Conversely, outperformance among smaller companies (to which equal weight has greater allocations) leads to reduced concentration and the likelihood of equal weight outperformance.

Exhibit 4 shows that this dynamic is exactly what has been observed historically. The S&P 500 Equal Weight Index’s cumulative relative total return versus the S&P 500 typically rose (fell) as concentration, measured by the cumulative weight of the largest five S&P 500 companies, fell (rose). This dynamic includes December 2020, when Equal Weight outperformed and concentration declined as the beginning of vaccine rollouts particularly benefited smaller companies that had been more impacted by the “COVID correction” last year.

The current market environment may present an opportunity for investors to consider Equal Weight in order to diversify away from some of the largest market constituents. The S&P 500 Equal Weight Index’s smaller size bias may also benefit investors anticipating reductions in market concentration.

Information Technology was the top-performing sector in 2020, up 44%, while Momentum (up 28%) was the second best-performing factor. These two results are reminiscent of the bubble we experienced two decades ago. But the Tech sector of today is not your father’s Tech sector. Similarly, we can analyze the market from a factor perspective and look at the characteristics of Momentum today versus in the late 1990s. In several respects, the differences outweigh the similarities.

First, the recent run-up in the S&P 500^® Momentum Index is much less extreme than during the late 1990s, as we see in Exhibit 1.

Moreover, Exhibit 2 illustrates that the relative volatility of Momentum was much higher then (December 1998-December 2000) than it is now, with an annualized standard deviation of daily relative returns of 15.9%—almost double the current period’s standard deviation of 8.1% (December 2018-December 2020).

Finally, there are significant differences in the current factor exposures of Momentum relative to December 1999. Exhibit 3 shows that the S&P 500 Momentum Index consistently has a strong tilt toward the Momentum factor. Stocks with large cap and low value exposures were outperforming both in 1999 and currently, leading to their inclusion in the Momentum index.

However, the Momentum index’s exposure to the low volatility factor has grown, and its exposure to the high beta factor has diminished. This suggests that the stocks within the current Momentum index are less volatile than they were 20 years ago, substantiating the results we saw in Exhibit 2.

In this era of mega-cap dominance and bubble-like euphoria, concerns about concentration naturally come to mind. Exhibit 4 illustrates that concentration in the S&P 500, measured by the cumulative weight of the five largest constituents, has increased considerably in the past year. The five largest stocks in the S&P 500 composed 20.2% of the total index by weight in December 2020, higher than the December 1999 levels of 16.6%.

If indeed we are in the midst of a bubble, it is important to understand the differences compared to past ones. And while timing the end of a bubble is no small feat, we know that the market experienced a reversal in Q4 2020, with the comeback of smaller caps and Equal Weight. If these trends continue, then a subsequent decline in concentration and shift in the factor make-up of the market could be in the cards.

Most investors are familiar with the S&P 500 index. Its mid and small cap counterparts, the S&P 400 and S&P 600 don’t get quite the same coverage in the financial press. Yet these are powerful tools that must not be overlooked.

1. Diversification of the Indices

2020 was indeed a peculiar year for US equities. As the virus brought on volatility, the recovery in equity market indexes was uneven – and largely driven by a handful of mega-cap companies. If we look at the S&P 500 in particular, the level of concentration in the top 5 names is now the highest it has been in 40 years (20.19% as of December 31, 2020). It is interesting to note that between the 1970’s and today, the highest level of concentration reached was in December 1999, prior to the tech bubble burst.

An important implication is that the S&P 400 and 600 index returns are less reliant on a handful of names, and may therefore be an effective tool for diversifying US equity exposure.

2. Historical Performance

Looking at very long term time periods, small and mid-size indexes have demonstrated superior performance when compared to large-cap only. 25 years of data show an outperformance of 186 basis points per year (S&P 400) and 99 basis points per year (S&P 600) compared to the S&P 500.

3. Why Consider These Indexes Now?

Small and medium sized businesses have been disproportionately impacted by the pandemic, and have lagged in recent years, but may present greater growth opportunities for long term investors moving forward. These mid and small cap indexes may be posed to benefit from “re-opening” and possible M&A activity ahead of us.

The S&P 400 and 600 have historically had a higher correlation to a number of economic indicators (GDP growth, investment and consumption growth). As the re-opening becomes more broad-based, if consistent with such higher correlations, these indexes may provide a higher beta, leading to outperformance versus the S&P 500.

These indexes can also serve as a complement to the S&P 500. While the 500 provides good exposure to big tech and healthcare, the 400 and the 600 provide a heavier weighting towards industrials, real estate, financials and consumer discretionary sectors – pro cyclical sectors that possibly stand to do well as the economy as a whole recovers.

In the final quarter of 2020, BMO GAM’s Multi Asset Strategy Team (MAST) increased their overweight to equities versus fixed income based on the imminent rollout of vaccines and “Whatever-it-takes” monetary and fiscal policies supportive of risk assets. We maintained an overweight to US equities, and increased our portfolio beta by overweighting small cap equities on vaccine optimism. We expect these themes to continue into 2021.

Join BMO on Wednesday, February 3rd for our Virtual ETF Economic Forum, and hear from expert panels on Fixed Income, Equities, and Innovation in ETFs. They will share comprehensive research and actionable ideas to position your clients for the future.