Indexology^® Blog

The S&P GSCI, the broad commodities benchmark, rose in September by 6.0%. Energy-related commodities were the outperformers on the back of what may prove to be a lasting global energy supply crunch. Agriculture and metals were mostly lower over the month.

Record natural gas and electricity prices in Europe, record coal prices in China, multi-year high natural gas prices in the U.S., and oil prices tipping USD 80 per barrel are all manifestations of a global energy shortage that came into sharp focus in September. The S&P GSCI Natural Gas rallied 32.9%, while the S&P GSCI Petroleum jumped 10.0% over the month. While OPEC+ has started gradually restoring the output that was shuttered at the height of the COVID-19 pandemic, the inability of some members to raise output to agreed levels due to underinvestment and maintenance is increasing the burden on top producers such as Saudi Arabia to meet strong post-pandemic demand.

Most commodities within the agriculture space moved lower in September, cooling off after strong YTD performance. The USDA’s Quarterly Grain Stocks Report confirmed that U.S. corn and soybean stocks were larger than expected, while U.S. wheat stocks were at a 14-year low. The S&P GSCI Soybeans dropped 2.8% over the month. The S&P GSCI Cotton was one of the few outperformers in the agriculture complex, moving higher by 14.4% due to the same weather-related issues faced by the energy sector. Much of the cotton-growing regions in the U.S. were in the path of Hurricane Ida earlier in the month.

The S&P GSCI Livestock fell 3.0% in September, with live and feeder cattle prices taking a hit on the supply side from high slaughter rates, and on the demand side from concerns over the longevity of beef export demand and the possible impact of inflation on U.S. consumers’ consumption patterns.

Industrial metals were a mixed bag, with most falling in September, but the S&P GSCI Aluminum moved higher by 5.0% and was up 41.4% YTD. Concerns regarding the availability of bauxite, the raw material used to produce aluminum, combined with power outages and a government crackdown on polluting industries in China, have greatly disrupted the aluminum supply chain.

The S&P GSCI Precious Metals fell 3.7%, as the U.S. dollar reached a new one-year high. As U.S. yields jumped higher, assets that provide no yield like gold or silver took the hit. Historically expected to provide a strong hedge to inflation, gold’s inflation beta has declined rapidly over the past two years, while other commodities like crude oil have shown a much stronger relationship to moves in inflation.

I recently had the pleasure of participating in a webinar on the basics of passive management. A portfolio manager in the audience posed an important question which I’ll paraphrase: “If my goal is to earn a return of X%, why is an index’s performance relevant?” Otherwise said, if I want to earn a particular absolute return, why should I care about returns relative to an index?

This is a good question, and the answer, like the answer to many good questions, is that “it depends.” What it depends on is the answer to a subsidiary question: if an investor’s goal is to earn a return of X%, by what means does he intend to pursue that goal?

There are many asset classes out there: one might buy gold bars, or bitcoins, or Old Master paintings. But for the most part, investors and fiduciaries pursue their absolute return goals by investing in securities. And in securities markets, index returns are relevant for at least two reasons.

First, properly constructed benchmarks define the investor’s opportunity set. Capitalization-weighted indices like the S&P 500^® are designed, in part, to track the value of a stock market; changes in the aggregate value of the stock market are reflected directly in the returns of the index. If the investor’s goal is to earn 8% annually, and the market in which he’s invested declines by 20% this year, he’s almost certainly not going to make it. And if the market index rises by 20%, he’s almost certainly not going to be satisfied with 8%. Absolute return is an aspiration; relative return is actionable.

Second, the returns of a portfolio relative to a market index are evidence of a manager’s skill. Clients have choices: they can own a market passively or attempt to outperform it actively. If the measure of success for an active manager is to outperform a benchmark appropriate to his investment style, the evidence is clear that most active managers fail most of the time; indeed over long time horizons, the advantage of index management is enormous.

Investors who are willing to accept index returns, therefore, typically see better results than those who strive to outperform. A willingness to forgo relative returns may be the key to improving absolute performance.

A question…

Take five major asset classes: U.S. stocks, international stocks, long-term government bonds, Treasury Bills, and REITs. If their respective compound rate of return over the past two decades is compared, which would come in highest?

Stocks?

Maybe bonds as they’ve ridden yields down to near zero?

Nope.

REITs win the day.

If returns for these asset classes over the past twenty years are compared, REITs returned the most, leading the way with a compound annual return of 10.4%.

There may be benefits of adding REITs to a traditional investment portfolio beyond historical returns.

Whether it’s farmland, apartment rentals, home builders, or commercial properties, real estate can be a diversifier when combined with a portfolio of equities and fixed income.

Now, when one thinks “REITs,” chances are “income” comes to mind. And many investors stop their analysis right there – which REIT yields the most? We believe this is a limited perspective.

Today, let’s highlight why by walking through what we believe is a more optimal way to structure a REIT portfolio.

Diversification Across the Globe

Across all asset classes, one of the biggest diversification mistakes that investors make – across all asset classes – is concentrating their investments in their own, home country.

For example, if the global stock market is weighted by size, the U.S. only accounts for a little over half of the total market-cap. But most U.S. investors allocate about 80% or more to US stocks.

Of course, this home country bias is not specific to U.S. investors. It exists all over the world and is even more pronounced in smaller countries since they command a much smaller percentage of global market-cap weights.

Only considering U.S. exposure when it comes to REITs could be a mistake.

However, considering global exposure is just the first step in creating balanced, optimized REIT portfolio. There are additional, beneficial steps one could theoretically take.

Incorporating Value, Quality, and Momentum Factors

Most people consider using factor investing when it comes to stocks, but what about REITs?

S&P has built a factor-based index focused on the global REIT sector. This S&P Global REIT Quality, Value & Momentum (QVM) Multi-Factor Index first starts with the S&P Global REIT Index universe. The index then screens for companies with specific attributes related to value, quality, and momentum. Real estate is a unique sector, and the index utilizes factors that are specific to REITs like funds from operations (FFO) and financial leverage levels.

Why would investors want to consider factors such as these when it comes to REITs?

The simple answer is: to break the market-cap weight.

We’ll examine this topic and how a multi-factor REIT approach may fit into a portfolio in Part II…

Disclaimer:

The views and opinions of any third-party author are his/her own and may not necessarily represent the views or opinions of S&P Dow Jones Indices or any of its affiliates.

The growth of passive investing has spurred suggestions that stock returns may be influenced by a so-called “index effect,” as trading by index funds responds to changes in index membership. If this were true, stocks added to the index would initially outperform amid buying pressure, while index deletions would underperform.

Our recent paper—“What Happened to the Index Effect: A Look at Three Decades of S&P 500^® Adds and Drops”—analyzes a sample of S&P 500 additions and deletions. We focused on the S&P 500 as it is the world’s most widely followed index; USD 5.4 trillion tracked the large-cap U.S. equity benchmark at the end of 2020, up from USD 577 billion at the end of 1996. Hence, if an index effect exists anywhere, one might expect it to appear for the S&P 500.

The results from our paper corroborate the general consensus reflected in the existing literature: the S&P 500 index effect seems to be in a structural decline. Indeed, Exhibit 2 shows a clear attenuation in the magnitude of excess returns (versus the S&P 500) for sample additions and deletions between the announcement date and the effective date over time. The reduction in the index effect is independent of the source of additions, the destination of deletions, or the companies’ sector classifications.

Our paper uses an implicit cost measure to track stock liquidity, and this measure reflects the market makers who sit between buyers and sellers. Trading does not happen instantaneously; market makers may have to hold inventory from one side of a trade before the other side has completed. All else equal, the risk of holding inventory increases when the passive assets that would have to trade a constituent change represent a larger portion of a stock’s median dollar value traded (MDVT). A greater movement in a stock’s price introduces greater risk for the market maker. In each case, the market maker may pass this risk onto investors as an additional cost for providing liquidity.

Exhibit 3 shows that changes in the implicit cost measure helped to explain more than 50% of the variation in median excess returns for sample additions between 1997 and 2021. In other words, an improvement in liquidity appears to have helped explain the attenuation in the index effect.

The SPIVA^® U.S. Mid-Year Scorecard continues to show that active funds’ strong absolute returns do not always translate into relative success compared with their benchmarks. In 15 out of 18 categories of domestic equity funds, the majority of actively managed funds underperformed their benchmarks. Over the 12-month period ending June 30, 2021, 58% of large-cap funds, 76% of mid-cap funds, and 78% of small-cap funds trailed the S&P 500^®, S&P MidCap 400^®, and S&P SmallCap 600^®, respectively.

Vast underperformance in the mid- and small-cap segments is particularly interesting in that these active funds managed to do better than their large-cap counterparts in recent reports. Given that their outperformance seemed to occur when the large-cap benchmark had a higher return than the respective mid- or small-cap benchmark (see Exhibits 1 and 2), it is more likely that mid-cap and small-cap fund managers are quietly edging into the larger-cap space and benefiting from the higher returns available there. The re-opening gains of early 2021 add one more data point to that hypothesis. As the rest of the market caught up to the large-cap rally of the initial pandemic phase, mid-cap and small-cap managers who tilted up the capitalization scale were caught leaning in the wrong direction.

This is the first time we included risk-adjusted SPIVA scores in the report. We consider volatility, calculated through the standard deviation of monthly returns, as a proxy for risk, and use return/volatility ratios to evaluate performance. After adjusting for risk, the majority of actively managed domestic equity funds in all categories underperformed their benchmarks on a net-of-fees basis over long-term investment horizons.