Indexology^® Blog

It’s been almost a year since the COVID-19 pandemic hit the U.S., but despite the disruption it brought to daily life, the U.S. equity market has performed remarkably well—rallying powerfully after a sharp decline in March 2020. Through Feb. 18, 2021, the S&P 500^® was up 24% since the end of 2019. In the same period, the S&P 500 Low Volatility Index was flat.

The Low Vol index rebalanced after the market’s close on Feb. 19, 2021; not much changed. With the lowest turnover in the history of the index, six names cycled out, accounting for about 5% of the index.

The biggest change was in Health Care, which gave up 3% of its weight. The slack was mostly offset by Information Technology. Real Estate lost a bit of ground as Industrials added about 1%. All other sectors held steady.

Dynamics in sectors provide us with some insight into what drove the changes in the latest rebalance. While volatility remains elevated, similar to the November 2020 rebalance, it continues to decline. Importantly, volatility declined by a similar proportion across all sectors, which explains the minimal turnover in the latest rebalance.

Whoever said size doesn’t matter, wasn’t talking about ESG. For years, we’ve known that larger companies tend to fare better when it comes to sustainability.¹ But thanks to the launch of the S&P MidCap 400^® ESG Index and S&P SmallCap 600^® ESG Index, that may be about to change.

As per the S&P ESG Index Series Methodology, the indices aim to offer benchmark-like returns and improved sustainability profiles relative to their benchmarks (see Exhibits 1-3). Above all, however, they represent a new sustainable frontier in a space left largely untouched by ESG indexing to date. Indeed, scant reporting of sustainability metrics among smaller-sized firms has thus far dampened ESG efforts below a certain cap size. But thanks to the rules-based selection process and direct company engagement of our annual Corporate Sustainability Assessment (CSA), the methodology is uniquely positioned to:

1. Educate smaller firms on sustainability topics of growing importance to investors;² and
2. Raise the bar on sustainable business practices as companies compete to join the ranks of the ESG indices.

Perhaps the biggest contribution these indices may make, then, is to influence greater reporting and sustainability standards among medium and small-sized firms—beyond just the typical titans of the S&P 500^®.

However, the fact remains that there is relatively less disclosure of ESG topics among smaller firms at present,³ and that larger companies tend to perform better on these issues (i.e., size really does matter).⁴ This positive correlation between ESG performance and firm size means that the standard ESG score exclusion criteria would likely result in an eligible universe that is simply too narrow to maintain a broad and diversified index.⁵ To remedy this, we apply minor adjustments to the methodology for the 400 and 600 versions to ensure the indices can satisfy the S&P ESG Index Series objective. For instance, screening out companies at lower ESG score thresholds where necessary and at the local index level, rather than among global industry group peers.⁶

With these adjustments, the resulting 274 constituents of the S&P MidCap 400 ESG Index and 407 constituents of the S&P SmallCap 600 ESG Index manage to closely replicate the underlying risk/return profile of the respective benchmark (with welcome outperformance; see Exhibit 1)—as well as provide measurable ESG improvements (see Exhibits 2 and 3). This result, coupled with an almost identical underlying factor exposure to their benchmarks (even when it comes to size, surprisingly) confirms that these new ESG indices are poised to do precisely what they are intended to do (see Exhibits 4 and 5). Thus, as these indices assume their rightful place alongside the flagship S&P 500 ESG Index, we can finally say that sustainable investing is no longer just a large-cap solution—it is now an all-cap solution.

For more on the S&P MidCap 400 ESG Index and S&P SmallCap 600 ESG Index, read the addendum to our white paper, “The S&P 500 ESG Index: Defining the Sustainable Core.”

¹ A positive correlation between sustainability performance and firm size is generally observed due to the greater visibility, access to resources, and operating scale associated with large firms. See, for example, Drempetic, S., Klein, C., and Zwergel, B. “The Influence of Firm Size on the ESG Score: Corporate Sustainability Ratings Under Review.” Journal of Business Ethics (2019) for more information.

² See Naqvi, M. and Jus, M. “The Benchmark that Changed the World: Celebrating 20 Years of the Dow Jones Sustainability Indices”, S&P Global (2019) for more information.

³ According to this WSJ article (2019), “Midsize and small companies generally lag behind their larger peers in terms of disclosure because they are less likely to have resources such as ESG-dedicated team or a sustainability department”.

⁴ See footnote 1.

⁵ As per the standard S&P ESG Index Series Methodology, companies with an S&P DJI ESG score that falls within the worst 25% of ESG scores from each GICS Global Industry Group are excluded from the indices (alongside other exclusions (tobacco, controversial weapons, thermal coal, companies that perform poorly on the UNGC principles, and companies involved in material controversies), before then targeting 75% of the remaining, eligible universe of companies ranked by S&P DJI ESG score within their respective index industry group.

⁶ See page 8 of the S&P ESG Index Series Methodology for more details on the adjustments made to the exclusion criteria for the S&P MidCap 400 ESG Index and S&P SmallCap 600 ESG Index.

⁷ The relatively low index-level ESG score improvement is a consequence of the generally low ESG scores among small- and mid-sized companies, as discussed. Please refer to Exhibits 2 and 3 to better understand the sustainability enhancements associated with the S&P MidCap 400 ESG Index and S&P SmallCap 600 ESG Index across the individual E, S, and G dimensions.

In April 2020, we launched the S&P PACT^TM (Paris-Aligned & Climate Transition) Indices. The indices aim to align with a 1.5^oC climate scenario, the EU’s minimum standards for EU Climate Transition Benchmarks and EU Paris-Aligned Benchmarks, and the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), while maintaining a broad, diversified exposure. The S&P PACT Indices consist of the S&P Paris-Aligned (PA) Climate Indices and S&P Climate Transition (CT) Indices. The index methodology excludes certain companies (exclusion effect), then reweights remaining constituents (reweighting effect) based on their climate performance (see Exhibit 1), as discussed in a previous blog.

We published a paper explaining the weight attribution of constituents in the S&P PACT Indices, where we isolated the transition pathway, environmental score, physical risk, and level of high climate impact revenue as important weight drivers. Elaborating on Barbara’s recent blog, we highlight observations of how sector allocations were driven by climate factors and exclusions within the S&P 500^® PACT and S&P Developed Ex-Korea PACT Indices.

Similar to the S&P Europe LargeMidCap PA Climate Index and the S&P Eurozone LargeMidCap PA Climate Index, the S&P Developed Ex-Korea LargeMidCap PA Climate Index and S&P 500 PA Climate Index saw large Energy exclusions due to oil, gas, and coal exposure. Within the S&P 500 PA Climate Index specifically, no Energy stocks were eligible due to these exclusions. Furthermore, the removal of highly intensive power generation companies affected Utilities.

However, unlike the S&P Europe LargeMidCap CT Index and the S&P Eurozone LargeMidCap CT Index, the Utilities sector of the S&P 500 CT Index experienced underweighting. While this was observed within the S&P 500 PA Climate Index due to additional power generation exclusions, the underweight in the S&P 500 CT Index was likely driven by climate factors, particularly high physical risk. Utilities companies were largely either well above or below their 1.5^oC budget (assessed by Trucost’s Transition Pathway dataset). The only overweighted Utilities company in the S&P 500 PA Climate Index had the lowest physical risk among its peers, despite being slightly above its allocated carbon budget.

While companies are not individually required to be 1.5^oC compatible for eligibility for the S&P PACT Indices, we observed those well over budget (around 10² in the S&P Developed Ex-Korea LargeMidCap PACT and S&P 500 PACT Indices) rarely saw any weight allocation, whereas those under budget frequently realize large overweighting.

Health Care experienced a large overweight in the S&P 500 and S&P Developed Ex-Korea LargeMidCap PACT Indices. In each region, we observed few Health Care companies well over their 1.5^oC budget, and high physical risk was rarely an issue.

High climate impact revenues were constrained to avoid greenwashing. Most sectors had both high and low climate impact revenues streams. High climate impact revenues made the biggest impact on weights at the company level within sectors, rather than at sector level. Within sectors that had a mix of companies with high and low climate impact revenue streams, those with majority low climate impact revenues tended to be underweighted. This is particularly apparent within the Consumer Discretionary and Health Care sectors, as seen on the right-hand charts of Exhibits 2 and 3.

While there are further observations that can be made from the exhibits in this blog, we hope this picks out some key points of interest.

So far in 2021, the fixed income market certainly hasn’t been very fixed—instead posting negative returns—nor has it offered much income, with yields of just over 1%. U.S. equity and bond indices both posted strong performance in 2020, driving up asset class correlations and dropping yields to new lows. So, when the 10-year U.S. Treasury Bond traded above 1% in January 2021 (incidentally the first time since March 2020), the stock and bond markets both fell, disappointing investors looking to the bond market for portfolio diversification and consistent income stream.

Looking at what is on the menu for yield-focused market participants, options appear limited. Government bonds, while negatively correlated to stocks, tend to have low yield. Credit markets tend to have higher income potential but present additional risks, such as default risk, interest rate risk, and higher correlation to equities.

Analyzing each of these risks, along with their potential rewards, is the key to revealing potential opportunity. For example, the S&P U.S. Investment Grade Corporate Bond Index and S&P U.S. High Yield Corporate Bond Index, which seek to measure the broad U.S.-dollar corporate bond market, have current yields of 1.75% and 4.99%, respectively. Investment-grade bond indices are more credit worthy, but they also carry higher interest rate risk (as measured by the weighted average maturity [WAM] as shown in Exhibit 2). When yields rose in January 2021, the S&P U.S. Investment Grade Corporate Bond Index fell the most among fixed income sectors.

Senior loans don’t have nearly the same degree of sensitivity to rising rates as corporate bonds.¹ Because loan rates reset quarterly or semiannually, yields keep pace with changes in prevailing interest rates. Constituents of the S&P/LSTA U.S. Leveraged Loan 100 Index, comprising the largest loans in the market, may not all carry the investment-grade ratings but may benefit from their senior secured status. According to S&P Global’s latest recovery study, bank loan recoveries averaged 79% compared with just 47% for bonds.

The S&P U.S. Preferred Stock QDI Index, comprising preferred stocks whose dividends may be taxed at long-term capital gains rather than punitive ordinary income rates, currently yields 5.66%. Preferred stocks typically do not mature and therefore are less sensitive to interest rates. However, they do have higher correlation to stocks as well as higher volatility relative to bank loans and investment-grade debt. Beyond the tax advantage of these stocks, the index outperformed the broad-based S&P U.S. Preferred Stock Index by 3.5% per year on an annualized basis.

Hunting for income in a yield-starved world comes with many challenges for market participants. By measuring the risk/return profile of various fixed income market segments, yield-hungry market participants will be able to make informed decisions.

¹ The degree of sensitivity to rising rates is measured by the weighted average life (WAL) of the S&P/LSTA U.S. Leveraged Loan 100 Index.

In part 1 of this blog, we saw how falling real interest rates reduce the retirement income a given account balance can support. In part 2, we focus on how interest rate risk may potentially be managed through an income-focused asset allocation.

The S&P STRIDE (S&P Shift to Retirement Income and Decumulation) indices measure the allocation shown in Exhibit 1. The allocation has two features that differentiate it from the glide path typically followed by regular target date indices. First, in an attempt to better manage market risk, the glide path of S&P STRIDE allocates 25% of index constituents to equities at the target date (or retirement), compared to about 50% for the industry average.¹ Second, the S&P STRIDE glide path includes a substantial index constituent allocation to long-maturity TIPS when approaching the target date, which is designed to help manage both interest rate and inflation risk. The S&P STRIDE allocation seeks to hedge this risk by including TIPS constituents with an interest rate sensitivity similar to the cost of 25 inflation-indexed payments starting at the target retirement date. This way, when interest rates decrease, the cost of future consumption goes up, but so does the account balance. With the appropriate TIPS portfolio, the two effects approximately offset each other, making retirement income less volatile.

How did the S&P STRIDE approach fare in 2020? Exhibit 2 considers the hypothetical experience of a cohort of investors retiring in 2020. We compare two index constituent allocations: the S&P STRIDE 2020 Index and the S&P 2020 Target Date Index, which seeks to represent the average asset allocation of U.S.-based 2020 target date funds.² Starting with a theoretical $1M investment at the beginning of 2020, the bars show the theoretical real income that each allocation can afford, determined by balance amounts and real interest rates at the beginning of each month.

The S&P 2020 Target Date Index performance was –4.3% in theoretical real income terms in 2020. By contrast, the S&P STRIDE 2020 Index performance was 1.6%, an outperformance of 5.9 percentage points. Importantly, this difference was not driven by the S&P STRIDE Index’s lower exposure to equities. Given that equity markets rebounded substantially since March 2020, this outperformance may be attributed to S&P STRIDE’s long-dated TIPS allocation. While bond constituents in the S&P 2020 Target Date Index offered some protection from interest rate risk, their maturities were too short to fully offset the theoretical income loss.

As eventful as 2020 was, S&P STRIDE Index’s income-focused approach proved its potential as a tool to help mitigate interest rate and inflation risk.

¹ Figure based on the S&P Target Date 2020 Index, which reflects the average asset allocation across 2020 target date funds. See S&P Target Date Scorecard Year-End 2019 (link) and S&P’s “Making STRIDEs in Evaluating the Performance of Retirement Solutions” (link).

² See “S&P Target Date Index Series Methodology” (link) for a complete description.

Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.

The S&P STRIDE Index Series was developed in collaboration with Dimensional Fund Advisors LP (“Dimensional”), an investment advisor with the U.S. Securities and Exchange Commission. Dimensional Fund Advisors LP receives compensation from S&P Dow Jones Indices in connection with licensing right to the S&P STRIDE Indices.