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No Safe Harbor for Stockpickers

Smart Factories to the Supply Rescue

Commodities Crushed It in 2021

Focusing on Factor Indices

Active Management: Naughty or Nice?

No Safe Harbor for Stockpickers

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Anu Ganti

U.S. Head of Index Investment Strategy

S&P Dow Jones Indices

We can use volatility and its components dispersion and correlation to analyze stock selection conditions globally. Most active managers run less diversified, more volatile portfolios than their index counterparts. Active managers should prefer above-average dispersion because stock selection skill is worth more when dispersion is high. The role of correlation is more subtle. While counterintuitive, the benefit of diversification is less when correlations are high. Therefore, they should prefer above-average correlations because it will reduce the opportunity cost of a concentrated portfolio. We observe in the U.S. that while 12-month average dispersion declined slightly, we saw a dramatic decline in correlations in 2021 compared to 2020.

Two years ago, we conceptualized the cost of concentration, defined as the ratio of the average volatility of the component assets to the volatility of a portfolio. A higher cost of concentration implies a larger foregone diversification benefit, translating into a higher hurdle for active managers to overcome.

How much higher do returns have to be to justify the additional volatility active managers take on? By multiplying the cost of concentration by a rate of return consistent with the market’s historical performance (e.g., 10% for the S&P 500), we arrive at the required incremental return shown in Exhibit 2 for the S&P 500. Driven by the lower correlations seen in Exhibit 1, this measure almost doubled last year, indicating that active managers gave up a larger diversification benefit in 2021 than in 2020.

Finally, to understand how difficult it is to earn this incremental return, we divide the required incremental return by dispersion to translate the measure into dispersion units. We can interpret a higher number of dispersion units to mean more challenging conditions for active management.

The bars in Exhibit 3 indicate the average value of the required incremental return in dispersion units for several indices across regions. As dispersion and correlations were generally lower, we observe a relatively more difficult environment for active management across most markets.

The challenging environment for stock selection is not unique to the U.S. 2021 stands in stark contrast to 2020, when both dispersion and correlations rose globally. Despite those relatively favorable conditions for stock selection, most active managers still underperformed, proving that true stock selection skill is rare. When SPIVA® results for 2021 become available, it would not be surprising if we saw dreary global active management performance once again.

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

Smart Factories to the Supply Rescue

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Justin Holt

Senior Director, Research & Design, S&P Kensho Indices

S&P Dow Jones Indices

With the global economy ramping up from the depths of the COVID-19 pandemic, labor shortages and supply chain bottlenecks are hampering manufacturers.

Fortunately, there is relief on the way. Digitalization is sweeping through manufacturing plants and transforming today’s sleepy mills into the smart factories of tomorrow. The catalysts include several of the technological forces driving the Fourth Industrial Revolution: exponential computing power, Big Data, artificial intelligence (AI), and machine learning (ML). The factory of tomorrow will be increasingly autonomous, self-optimizing, and sustainable.

The S&P Kensho Smart Factories Index seeks to track the companies that are enabling this manufacturing revolution. The index includes companies from across the full innovation ecosystem with an emphasis on the following four key technologies.

  • Digital Manufacturing Solutions (52.6% of index weight1): Covers the software enabling connected, integrated digitalization of manufacturing activities, including the equipment used for environment sensing and monitoring, advanced process control, and predictive maintenance. Led by cloud adoption, digital transformation with remote capabilities has gone from nice-to-have to need-to-have.
    • Per an Intel research report,2 manufacturers experience up to 800 hours of unscheduled downtime annually (30% of it unplanned), while their skilled workers are aging, leaving 2 million jobs at risk of not being filled.
    • Cost savings and waste reduction are additional catalysts to adoption. A McKinsey study3 found that AI-enhanced predictive maintenance of industrial equipment can generate a 10% reduction in annual maintenance costs, up to a 20% downtime reduction, and a 25% reduction in inspection costs.
  • The Industrial Internet of Things (IIoT) (22.9% of index weight): Represents the interconnection of big, ubiquitous data, sensors, instruments, and other devices networked together with computers’ industrial applications. It is key to facilitating manufacturers’ ability to connect, automate, track, and analyze industrial activities.

The IIoT provides real-time asset performance monitoring solutions, enabling operators and supervisors to visualize trends graphically from anywhere in the world on any connected device.

  • Industrial Machine Vision (17.2% of index weight): Includes technology that combines sensors, cameras, computers, and ML/AI with visual data to identify product defects and model and predict equipment processes and product results.
  • Digital Twins Technology (7.3% of index weight): Provides a virtual replica of any physical product, piece of equipment, or asset. For example, a digital twin could be a virtual version of a manufactured product, the entire production line, an entire factory, or network of plants.

Big results are expected from digital twins. Gartner4 predicts that organizations will save USD 1 trillion per year in maintenance costs by using digital twins.

In Exhibit 1, we can see the five-year forward growth outlook5 for each key technology and 2021 performance of companies in each segment.

The digitalization of factories promises to upend established manufacturing practices. The S&P Kensho Smart Factories Index offers niche market exposure that is well differentiated from the more traditional emphasis of legacy industrial-focused indices.

 

1 As of Dec. 31, 2021. Index weight totals are based on companies’ product segment mappings.

2 Intel Research. https://s21.q4cdn.com/600692695/files/doc_downloads/intelligent-factory-infographic.pdf

3 McKinsey Research. https://www.mckinsey.com/~/media/mckinsey/industries/semiconductors/our%20insights/smartening%20up%20with%20artificial%20intelligence/smartening-up-with-artificial-intelligence.ashx

4 Gartner Digital Twin Forecasts. https://www.ey.com/en_au/advanced-manufacturing/how-digital-twins-give-automotive-companies-a-real-world-advantage

5 Digital Manufacturing Solutions Growth. https://www.mordorintelligence.com/industry-reports/digital-transformation-market-in-manufacturing

IIoT Market Forecast. https://www.prnewswire.com/news-releases/industrial-iot-market-worth-106-1-billion-by-2026–exclusive-report-by-marketsandmarkets-301325443.html

Industrial Machine Vision CAGR. https://www.marketsandmarkets.com/PressReleases/industrial-machine-vision.asp

Digital Twins CAGR. https://www.mobinius.com/blogs/digital-twin-trends/

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

Commodities Crushed It in 2021

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Jim Wiederhold

Former Director, Commodities and Real Assets

S&P Dow Jones Indices

The market standard commodities benchmark, the S&P GSCI, crushed it in 2021, rising 40.35% and outpacing other similar commodity indices and asset classes, as high and rising inflation provided a great backdrop for this inflation-sensitive asset class. Commodities finished strong in December, rising 7.59% over the month as energy bounced back and Omicron COVID-19 variant concerns were brushed aside, with global demand still humming. Supply chain bottlenecks are slowly easing, but freight costs around the world continue to be elevated, contributing to higher commodity prices.

With the highest weight in the S&P GSCI, the S&P GSCI Energy was responsible for most of the strong performance seen in December and throughout 2021. Every petroleum-based commodity rose by double-digit percentages in December and by at least 58% throughout the year. A combination of strong global demand and reduced oil production due to climate concerns helped petrol to post its strongest yearly performance since 1999. On the other hand, the S&P GSCI Natural Gas continued its decline, posting another 17.57% drop in December as warmer weather reduced demand for one of the main ways to heat buildings in the northern hemisphere.

The S&P GSCI Industrial Metals finished the year strong by rising 5.02% in December. The S&P GSCI Aluminum rose the most in 2021, by 38.43%. In a similar narrative to energy-related commodities, aluminum mining and production (which is typically carbon intensive) was curtailed while demand remained strong, especially for electric vehicles. This green transition friction caused prices to outperform the other industrial metals throughout the year. The S&P GSCI Zinc was the second-best performer, rising 28.03% in 2021 and showcasing an exceptionally strong December rise. Supply disruptions for aluminum and zinc are forecast to continue, with exchange warehouse inventories already low and more metal due to leave particularly from the London Metal Exchange.

The S&P GSCI Agriculture rose 24.70% in 2021. The most liquid corn, soy, and wheat commodities saw positive gains for the year, as weather-related supply disruptions were seen throughout the year, and demand came back strong compared to 2020. Incentivized by higher prices, more crop was planted but the demand side continued to prove to be a positive catalyst. The S&P GSCI Cocoa was the only constituent to show negative 2021 performance, at -6.27%. Its other soft commodity cousin, coffee, instead blew past all other agriculture commodities. The S&P GSCI Coffee beat crude oil with a positive 63.71% 2021 performance. It was the best yearly performance for coffee since 2010, the year several major studies were released in North America hyping the cancer-fighting and exercise-performance-enhancing benefits of a cup of coffee.

The S&P GSCI Livestock rose 7.9% in 2021, with lean hogs pulling the weight. Live cattle and feeder cattle prices were flat, but the S&P GSCI Lean Hogs rose 25.06% this year. Demand for pork was strong throughout the year and in another example of inflation everywhere, fast food prices rose considerably as bacon prices moved higher. The cost of a bacon, egg & cheese sandwich may continue to rise, with current high inflation seen broadly.

The S&P GSCI Precious Metals dropped 5.13% on the year as rates moved higher, market volatility came down, and demand for safe havens diminished. Gold’s historically strong inflation hedging ability and safe-haven status were challenged the most this year with crypto becoming prominent, and prices reflected this struggle.

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

Focusing on Factor Indices

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Anu Ganti

U.S. Head of Index Investment Strategy

S&P Dow Jones Indices

Factor indices have two important uses. First, they can be used as benchmarks to help clients of specialist managers disentangle how much of the manager’s performance is attributable simply to factor exposure, and how much is attributable to the manager’s stock selection beyond the factor. Second, factor indices can be used as investment vehicles to “indicize” a factor or set of factors, thereby delivering in passive form a strategy formerly available only via active management.

Our recently released paper, Factor Indices: A Simple Compendium, describes S&P DJI’s approach to eight factors: value, dividend yield, growth, quality, momentum, size, low volatility, and high beta. For each factor, we ranked the constituents of the S&P 500® by factor score, sorting them into equal-weighted quintiles, where Quintiles 1 and 5 contain the stocks with the highest and lowest factor exposure, respectively.

Taking value as an example, Exhibit 1a shows that the cheapest quintile of value stocks handily outperformed the others over time. Quintiles 2-4 are relatively close together, with Quintile 5 trailing. In contrast, Exhibit 1b shows that the quintile analysis for momentum supports an exclusionary approach to portfolio construction, as Quintiles 1-4 are clustered together, while Quintile 5 underperformed significantly. These results show that the performance of quintiles varies across factors; this has important implications for index design. 

Factor performance also varied across different market regimes. Exhibit 2 shows that Quintile 1 of value, size, and high beta outperformed during rising markets, while Quintile 1 of dividend yield, quality, momentum, and low volatility outperformed during down markets, highlighting their defensive characteristics.

Exhibit 3 allows us to make several other observations about these factors. For the period from 1991 through 2020, Quintile 1 of value, size, and high beta were more volatile than their Quintile 5 counterparts. Looking at Quintile 1 across factors, low volatility had the highest Sharpe Ratio, and quality had the highest Information Ratio. The average market cap of Quintile 1 was greater than that of Quintile 5 for dividend yield, growth, quality, momentum, and low volatility, illustrating a large-cap bias.

Understanding performance differences across factor quintiles is critical to understanding index performance and optimizing index construction.

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

Active Management: Naughty or Nice?

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Craig Lazzara

Managing Director, Index Investment Strategy

S&P Dow Jones Indices

The history of active investment management is, for the most part, a history of failure and frustration. Most active managers underperform most of the time, and success in one period seems not to predict subsequent success. We have long argued that active underperformance is not coincidental—it happens for identifiable and understandable reasons, and is therefore likely to continue.

But—most of the time is not all of the time, and most active managers are not all active managers. Some market environments may be more conducive to relatively favorable (or, to be precise, relatively less unfavorable) active performance. As I write in mid-December, 2021 is far enough advanced for us to attempt some informed speculation about what SPIVA® will reveal when the final results are in.

There are both positive and negative signals about the prospects for active management:

  • One of the most consistent challenges for active managers arises because, in most years, most stocks in the S&P 500® underperform the index. Returns are typically driven by a relatively small number of strong performers, which pull the index’s return above that of most of its constituents. Through the end of November, this was precisely the situation in the S&P 500: the index was up 23%, versus a gain of only 19% for the median stock. Only 42% of index members outperformed through the first 11 months of the year. Needless to say, fewer outperformers make for more challenging stock selection.

  • Strong markets historically have been somewhat more challenging for active managers; this is particularly true when the strong market is driven by some of the index’s largest names. Exhibit 2 shows us that the largest 50 stocks in the S&P 500 are comfortably in the lead for 2021. While it’s relatively difficult for active managers to overweight the largest names in their benchmark index, the reverse is not true. In fact we’ve found that large-cap managers tend to do better in periods when the superior performance of mid- or small-cap names gives them a chance to “cheat” (I use the term lovingly) down the cap scale. Not this year—although the performance of larger names may give mid- and small-cap managers an edge.

 

  • Dispersion began the year at a relatively modest level, but has recently begun a noticeable rise, closing November well into the top quartile of its historical range. Although dispersion tells us relatively little about the success of active managers as a group, heightened dispersion suggests that the range of active outcomes will be greater than usual. The best active performers should shine, as the value of stock selection skill rises when dispersion is high.

Readers can form their own opinions about the proper balance of these observations. Recognizing the hazard intrinsic to all predictions, my guess is that when we draw a line under 2021, active underperformance, at least for large-cap U.S. managers, will persist.

Of course, the conditions that make active management more or less difficult can change. If, e.g., 2022 sees a declining market, with megacaps and lower volatility names leading the way down, it’s conceivable that active underperformance could become less prevalent. That may be cold comfort to the active management community and its customers—but sometimes cold comfort is all the comfort there is.

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