Indexology^® Blog

In our previous blog, we’ve shown that SPACs tend to be small- and micro-cap companies that have low liquidity. Following the same framework, in this blog we will analyze SPACs’ performance. We found that relative to S&P SmallCap 600®, active SPACs underperformed when seeking the target, delivered abnormal returns during the deal announcement period, and underperformed again post-merger.

SPACs’ Performance Peaks Leading Up to Announcement Day

Exhibit 1 summarizes SPACs’ excess return over the S&P SmallCap 600 post-IPO and post-completion. Exhibit 2 shows how daily excess returns changed 30 days before and 30 days after the deal announcement. Finally, Exhibits 3-6 show the distribution of excess returns. The data highlights the following:

1. Post-IPO, SPACs underperformed the S&P SmallCap 600 (see Exhibit 1). The distribution of the excess return was heavily skewed (see Exhibit 3).
2. SPACs outperformed the S&P SmallCap 600 dramatically upon deal announcement (see Exhibits 2 and 4). Reflecting the market’s general positive sentiment, the percentage of SPACs that outperformed increased toward the deal announcement (see Exhibit 1). The abnormal return observation during the announcement day is consistent with previous research.¹
3. After the deal announcement, the excess return distribution was pushed to extremes, with large positive and negative excess returns observed. The mean excess return, however, was about 0. Holding SPACs 30 days post-deal announcement, in general, led to underperformance versus the S&P SmallCap 600 (see Exhibit 5).
4. Post-deal completion, we observe a heavily skewed distribution of excess returns, with an increasing negative skewness, the further away from completion (see Exhibit 6). This observation is also consistent with previous studies documented that post-merger SPACs are value-destroying to investors.²

We remain cautious in assessing post-merger performance because most SPACs listed in 2020 and 2021 are still looking for targets. As the number of SPACs proliferate, how they perform post-merger will be worth monitoring going forward.

¹ Rodrigues, U., & Stegemoller, M. (2014). What all-cash companies tell us about IPOs and acquisitions? Journal of Corporate Finance, 29, 111-121.

² Lakicevic, M., & Vulanovic, M. (2013). A Story on SPACs. Managerial Finance, 39(4), 384-403. Dimitrova, L. (2017). “Perverse incentives of special purpose acquisition companies, the “poor man’s private equity funds.” Journal of Accounting & Economics (JAE), Vol. 63, No.1, 2017. Klausner, Michael D. and Ohlrogge, Michael, A Sober Look at SPACs (October 28, 2020). Stanford Law and Economics Olin Working Paper No. 559, NYU Law and Economics Research Paper No. 20-48

International equity investors have long participated in the U.S. market, but their interest has often focused on the globally recognized blue chips included in benchmarks such as the Dow® and the S&P 500®. In doing so, they may be missing out on the long-term outperformance of smaller companies; presently, they may also be missing out on a diversification and growth opportunity that is “hidden in plain sight” within the global equity landscape.

The reluctance of international investors to venture down the capitalization scale may be due to concerns over the liquidity of smaller names, or potentially to a perception that smaller-stock allocations required active management (with the disappointing performance that active management often entails). But with low-cost, tradeable products tracking indices like the S&P MidCap 400^® and the S&P SmallCap 600^® being made available internationally, the opportunity set is changing.

In a new paper, we examine the international case for exploring beyond the S&P 500 in U.S. equities. As well as arguing that they can provide diversification, particularly when large-cap concentrations are at relatively high levels, we also argue that the U.S. small- and mid-cap segments may be poised to benefit most from an expected surge in U.S. GDP growth. Of course you should read the full paper here; to whet your appetite, here are our top three takeaways and charts:

1. U.S. small and mid caps are a significant part of the global equity market, larger in size than France and most major European nations.

2. European fund investors have so far made only minimal allocations to smaller U.S. companies, particularly when compared to their weight in the global markets, or when compared to U.S. large cap allocations.

3. Historically, companies further down the capitalization scale have tracked trends in U.S. GDP more closely than their large-cap counterparts. And while the largest American companies outperformed in the latter part of the 2010s, it left U.S. large caps relatively concentrated in a few large, internationally focused names. It’s no coincidence that a return to strong growth expectations for the domestic economy has seen small and mid caps begin their comeback.

For those based in the U.S., the lack of international demand for small and mid caps could imply a structural price discount; for those outside, this may also represent an opportunity to access a return stream largely ignored by their peers. With the growth in liquid, low-cost, index-based products, market participants worldwide are offered new options for broad-based access to a major source of potential diversification and growth.

A CRITICAL DISTINCTION TO BE MADE

When the pandemic began, many investors feared widespread dividend cuts. However, while some companies did cut or suspended their dividends, the damage was largely confined to the pandemic’s early stages. Once the economy began to stabilize, so did dividends. By the end of 2020, approximately three times as many companies in the S&P 500 raised their dividends as cut them.

This distinction in dividend policy had a significant impact on performance. Across the market-cap spectrum, dividend growers outperformed dividend cutters by approximately 20%. Dividend strategies focused on high yield (represented by the Dow Jones U.S. Select Dividend Index) held proportionately more dividend cutters and saw their performance struggle. Dividend growth strategies (represented by the S&P 500 Dividend Aristocrats Index) fared much better.

WHERE IS THE DIVIDEND GROWTH?

Although more companies grew their dividends than cut them in 2020, the rate of dividend growth among large-cap stocks has actually been trending lower for the last several years. And mid-cap stocks fared even worse, posting a dividend decline of roughly 8% for 2020.

Against this backdrop, one obvious place to look for sustainable and increasing income is dividend growth strategies. While dividends for the broad-market indexes were flat or down, S&P Dividend Aristocrat strategies delivered robust rates of dividend growth.

FINDING DURABLE DIVIDENDS IN 2021

Analyzing cash flows can help identify companies capable of producing durable dividends. Over time, companies must create enough cash flow to pay expenses, invest in their business via capital expenditures, service their debt, and (sometimes) return money to shareholders via dividends and buybacks.

Free cash flow (“FCF”) measures the cash left over after a company pays its operating expenses and capital expenditures, and it represents the resources available to pay dividends.

Cash Flows from Operations (CFO) – Capital Expenditures = Free Cash Flow

Free cash flows can be turned into a payout ratio by calculating how much the company’s free cash flows it pays out in dividends.

Dividends / Free Cash Flow = Free Cash Flow Payout Ratio

A lower payout ratio gives companies the flexibility to continue paying and growing dividends, even if cash flows fluctuate. In contrast, companies with high payout ratios have very little flexibility and may have to cut or suspend dividends if earnings and cash flow falter. Dividend growth strategies generally appear better positioned, relative to high dividend yielding strategies, to sustain and grow their dividends.

While the worst of the pandemic’s impact on dividends appears to be behind us, we urge dividend investors to remain vigilant. Making a distinction between dividend growth and high yield strategies had important implications in 2020, and it will remain a key topic moving forward in 2021.

This is not intended to be investment advice. Any forward-looking statements herein are based on expectations of ProShare Advisors LLC at this time. ProShare Advisors LLC undertakes no duty to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Investing is currently subject to additional risks and uncertainties related to COVID-19, including general economic, market and business conditions; changes in laws or regulations or other actions made by governmental authorities or regulatory bodies; and world economic and political developments.

The “S&P 500® Dividend Aristocrats® Index” and “S&P MidCap 400® Dividend Aristocrats Index” are products of S&P Dow Jones Indices LLC and its affiliates. All have been licensed for use by ProShares. “S&P®” is a registered trademark of Standard & Poor’s Financial Services LLC (“S&P”) and “Dow Jones®” is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”) and have been licensed for use by S&P Dow Jones Indices LLC and its affiliates. ProShares have not been passed on by these entities and their affiliates as to their legality or suitability. ProShares based on these indexes are not sponsored, endorsed, sold or promoted by these entities and their affiliates, and they make no representation regarding the advisability of investing in ProShares. THESE ENTITIES AND THEIR AFFILIATES MAKE NO WARRANTIES AND BEAR NO LIABILITY WITH RESPECT TO PROSHARES.

The recently published SPIVA^® Latin America Year-End 2020 Scorecard shows that the volatile environment of 2020, though potentially favorable for high-conviction active managers, did not necessarily translate into success for active managers.

SPIVA scorecards measure the performance of active funds against an appropriate benchmark. For Latin America, S&P Dow Jones Indices began publishing the scorecard in 2014, covering Brazil, Chile, and Mexico.

As of year-end 2020, all categories across all three countries underperformed their benchmarks over the 1-, 3-, 5-, and 10-year periods. These results contrasted those of the SPIVA Latin America Mid-Year 2020 Scorecard, in which Brazilian active managers in the Brazil Equity Funds, Brazil Large-Cap Funds, and Brazil Corporate Bond Funds categories managed to take advantage of the circumstances and outperform over the one-year period (see Exhibit 1).

Median fund managers across all the categories in the report underperformed their benchmarks over 1-, 3-, 5-, and 10-year periods (see Exhibit 2). However, in five out of seven categories, active managers in the first quartile beat their benchmarks over the one- and three-year periods (see Exhibit 3). Top-performing managers in the Brazil Equity Funds category were even able to outperform over the 10-year period.

As evidenced by SPIVA scorecards, the majority of active managers underperform most of the time, especially across the long-term time horizon. Is outperformance luck or skill? Stay tuned for the upcoming Latin America Persistence Scorecard.

Following a public consultation that concluded in March this year, S&P DJI announced the new composition of the S&P Global Clean Energy Index, which currently comprises 30 leading clean energy-related stocks, on April 2, 2021. The index is set to broaden when changes take effect on April 19, 2021.

Clean energy is an area that has garnered much investor attention over the past year, fueled in part by falling prices of renewables and growing momentum for carbon neutrality. As the global clean energy sector evolves, the S&P DJI Index Committee aims to have a benchmark that reflects the changing opportunity set.

Methodology Changes Lead to the Introduction of 51 New Stocks¹

The index will now aim to add all stocks with the purest clean energy exposure (exposure score of 1) without any limit on target number of companies. If there are fewer than 100 eligible stocks, then companies with lower exposure scores are added (up to 100) without breaching a defined dilution threshold.²

Despite an increase in constituent count, there was a slight decrease in the index’s weighted average exposure score (see Exhibit 1). The expectation of a sizeable reduction in volatility could help improve its risk/return profile as the theme continues to take shape in the years to come.³

Higher Liquidity

The consultation proposal outlined the goal to reduce constituent concentration, ease liquidity limitation, and improve index replication. The forthcoming changes seek to address these objectives in several ways, including increasing constituent count and introducing a liquidity weight multiple cap.⁴ Our analysis⁵ confirms notable improvements.

Exhibit 3 compares the liquidity profile for current and pro-forma compositions, as determined by the individual stock members. The maximum index liquidity is typically determined by identifying the constraining constituent.⁶ This may not necessarily be the least liquid stock, as the stock weight plays a role too. As shown, the capacity available to trade 90% of the index increases by six times. A similar magnitude of improvement is observed for trading 100% of the index (USD 333 million versus USD 51 million).

Stock ownership⁷ is another meaningful measure from an index replication standpoint. Our assessment based on a hypothetical USD 15 billion index portfolio reveals a significant reduction in concentrated ownership (see Exhibit 4), further attesting to the merit of the changes.

Elevated Trading Volumes Could Provide Liquidity for the Rebalance

While the changes are positive, they will result in a degree of turnover. Our estimates indicate that the one-way turnover is likely to be about 55%.

That said, larger rebalance events are typically preceded by an increase in trading activity. To investigate this, we compared the average daily stock liquidity for the six-month period prior to the consultation announcement (six-month ADV) to the volumes since April 2, 2021.⁵ Exhibit 5 confirms a sharp rise in trading activity for stocks with high days to trade (based on a hypothetical USD 15 billion portfolio and six-month ADV). If volumes remain elevated, the impact of the rebalance may well be attenuated.

What’s Next?

During the March 2021 consultation, the Index Committee also proposed to include emerging markets-listed stocks⁶ and expanding the clean energy business definition to include other eligible segments (e.g., energy storage companies). As these proposals were not intended for implementation in April 2021, S&P DJI intends to publish an additional consultation upon the completion of the upcoming rebalance. S&P DJI continues to monitor and seek feedback to ensure that the S&P Global Clean Energy Index appropriately meets its objective as this segment continues to evolve and develop.

¹ Full details of the methodology changes can be found here.

² Dilution threshold is defined by the index weighted average exposure score, which is set to 0.85.

³ Brzenk, Phillip. “Why Clean Energy Now.” Indexology^® Blog. Feb. 2, 2021.

⁴ Liquidity weight multiple cap is an additional cap imposed to ensure that a stock’s representation is in line with its liquidity. This cap is set at five times. Liquidity Weight Multiple Cap = Multiple*(Stock Liquidity/Aggregate Liquidity of all Stocks)

⁵ Based on daily tradable liquidity and ownership concentration.

⁶ Stock implied index liquidity is calculated for each stock in the index by dividing stock daily turnover by stock weight. The stock that implies the smallest value (constraining stock) determines the maximum index liquidity. For daily turnover, we assume 20% participation.

⁷ Measured by dividing the U.S. dollar notional held in any stock by its total market capitalization.

⁸ A hypothetical composition was released on March 12, 2021, as part of the S&P Global Clean Energy Index Consultation (based on October 2020 rebalance reference data).

⁹ Emerging markets stocks listed on developed exchanges are currently included.