Indexology^® Blog

The poet tells us that in spring, a young man’s fancy lightly turns to thoughts of love. Experience tells us that in January, an active manager’s fancy turns to thoughts of triumph.

Earlier this month, we learned that 70% of the institutional investors questioned in a recent poll thought that “markets will favor active management” in 2022. A number of reasons were cited for this belief, prominent among them the high level of concentration in some equity indices. Interestingly, this forecast of imminent active success is just the latest link in a long chain of similar predictions. For example:

• We were told that falling correlations would produce a “stock-picker’s market” in 2014.
• A year later, some active managers asserted that, with the market near then-all-time highs, active managers in 2015 were needed to mitigate portfolio risks.
• More recently, it was claimed that active managers would outperform passive benchmarks due to the high level of volatility in 2019.

What did 2014, 2015, and 2019 have in common? In each of those years, a majority of U.S. large-cap active managers underperformed the S&P 500^®. Indeed, of the 20 years for which SPIVA^® data exist, a majority of large-cap managers outperformed only three times (most recently in 2009). The records for mid- and small-cap managers, and for active managers outside the U.S., are equally disappointing.

In other words—active managers frequently predict that we are, or soon will be, in a “stock-picker’s market,” but the stock-picker’s market, like the fabled Brigadoon, almost never arrives. Whenever you hear a forecast that this will be the year in which active management is vindicated, here are some questions for the forecaster: If you know that active management will outperform this year, did you know that passive would outperform last year? If you knew, why didn’t you say so then? And if you didn’t know then, why should we believe that you know now?

You may end up with fewer friends, but you’ll have more clarity on an important investment issue.

Index construction matters when seeking to understand differences in index characteristics and any resulting divergences in index performance. One of the clearest examples of the importance of index construction comes when comparing the S&P SmallCap 600^® and the Russell 2000. Indeed, while both indices are designed to measure the performance of the small-cap U.S. equity segment, their historical performance is a tale of two small-cap benchmarks: the S&P 600^TM has outperformed by 1.8% on an annualized basis since 1994.

Contributing to the S&P 600’s historical outperformance was its banner year in 2021: Exhibit 2 shows that the S&P 600 beat the Russell 2000 by a stonking 12% in 2021, a far cry from its 8.7% underperformance in 2020. Such a sizeable shift may have some scratching their heads, but explanations for the S&P 600’s relative returns once again highlight that index construction matters!

A key difference between the two indices is that the S&P 600, unlike the Russell 2000, employs an earnings screen; companies must have a history of positive earnings before being considered eligible for S&P 600 addition. This contributes to the S&P 600 having significant, positive exposure to the quality factor, while the same is not observed for the Russell 2000. Unsurprisingly, perhaps, the S&P 600’s relative returns have typically been higher when the reward to quality was higher.

For example, Exhibit 3 compares the S&P 600’s calendar year relative returns against the average monthly quality factor return in the corresponding year. Clearly, the average monthly reward to the quality factor changed dramatically between 2020 and 2021, contributing to the S&P 600’s turnaround.

Another impact of the S&P 600’s earnings screen is that it has less exposure to the Health Care sector, including many biotechnology companies, as many of them lack the required history of positive earnings to be considered eligible for addition to the S&P 600. Hence, and as shown in Exhibit 4, the S&P 600 did not benefit nearly as much as the Russell 2000 from many investors focusing on Health Care companies involved in developing COVID-19 vaccines in 2020.

However, the sector-led bounce back observed in the first three quarters of 2021 continued until year end. The S&P 600 was more insulated from heavy declines in many biotech names last year—the S&P Biotechnology Select Industry Index was the worst-performing S&P Select Industry Index in 2021—and the S&P 600 also benefited from its choice of stocks within many sectors. Focusing on profitable companies appeared to help amid renewed optimism over the U.S. economic outlook.

As a result, the S&P 600’s relative returns over the past couple of years offer a case study on the importance of index construction. While there are no guarantees when it comes to performance, more than 27 years of live index performance helps to explain why:

“If you’re an active manager, you probably want to compare yourself to the Russell; if you’re a passive manager, you probably want to track the S&P.”¹

¹ https://www.bloomberg.com/opinion/articles/2022-01-20/small-caps-may-hold-value-for-investors-seeking-safety-in-rolling-correction

How does profitability influence risk and return in small-cap equities? S&P DJI’s Raghu Ramachandran and Garrett Glawe join Vanguard’s Ilene Kelman and Cardinal Investment Advisors’ Matt Padberg to take a closer look at aligning index objectives with strategic objectives.

2021 started on a hopeful note, with COVID-19 vaccines coming to save the world. However, as in many other parts of the world, Latin American countries struggled to control the pandemic’s impact on their economies and societies. Additionally, political uncertainty and civil unrest in several countries contributed to a disappointing year.

While most global markets experienced strong performance in 2021, the S&P Latin America BMI finished the year down 12%, with negative returns in three out of four quarters. It is interesting to note, however, that Latin America excluding Brazil had a different outcome, as the S&P MILA Pacific Alliance Composite gained 6.7% for the year (see Exhibit 1).

While headline indices from Argentina, Chile, Colombia, and Peru all closed 2021 in positive territory in local currencies, Mexico was the standout performer among Latin American countries as the S&P/BMV IRT gained 24.4% YTD (see Exhibit 2). The story was different in U.S. dollar terms, as all markets except for Argentina and Mexico ended in the red due to local currency depreciation against the U.S. dollar.

Brazil was the worst performer in 2021 in both Brazilian reals and U.S. dollars. Most Brazilian sectors underperformed; Financials, represented by the S&P Brazil BMI Financials Index (-24.3%), had significant losses and the greatest impact on the entire market. Mexico, on the other hand, had the largest annual gain since 2009, as shown by the S&P/BMV IRT. Most of this was driven by the double-digit gains of some of the largest Mexican companies like America Movil, Cemex, and Walmart de Mexico.

In terms of regional sectors, nearly all of them struggled to stay afloat (see Exhibit 3). In the end, for 2021, Communication Services (19.2% YTD), Consumer Staples (5.7% YTD), Energy (10.0% YTD), and Materials (3.1% YTD) were the only ones that accomplished that goal. The pandemic drove most people indoors to work, play, and shop. In Communication Services, companies like America Movil, Grupo Televisa, and Telefonica Brasil greatly benefited from increased subscribers to their online and pay TV services. Energy was driven up by solid annual price performances from Petrobras and Ecopetrol, which represented nearly 77% of the Energy sector. Consumer Staples, typically a reliable defensive sector, did not disappoint. Finally, Materials companies, which include producers of building materials, benefited from high demand for their products. Likewise, mining companies, particularly copper exporters, gained from historically high prices for their exports in 2021.¹ On the downside, Financials, the largest sector in the region, was down 21.6% for the year. Brazilian financial institutions, representing 64% of the sector, had the most losses for the year, greatly contributing to the region’s disappointing returns.

As the COVID-19 pandemic continues to evolve, uncertainty envelops the region at the start of 2022. High inflation, weakness in local labor markets, expectations for rising interest rates, and political instability in several Latin American countries continue to weigh on equity market sentiment. All this points to what could be a significant shift in economic and governmental policies in 2022. For better or for worse, it promises to be another fascinating year.

For more information on how Latin American benchmarks performed in Q4 2021, read our latest Latin America Scorecard.

¹ Source: S&P Global Ratings and CapitalIQ. Copper (Comex HG).

Equity markets have changed considerably over the past 10 years, reflecting the growth of stocks and sectors in each market. While this growth has led to increased concentration in most of the world’s largest equity markets, Australia is a notable exception, as diversification has improved both in terms of stock concentration and along sector lines.

We can analyze stock concentration at a high level by using the Herfindahl-Hirschman Index (HHI). This index is a widely used measure of market concentration that can also be applied to stock market indices. It is calculated by squaring the market share (weight) of each stock in an index and then summing the resulting numbers. A greater HHI indicates a higher level of market concentration, while a lower value indicates less concentration.

Exhibit 1 shows that market concentration declined significantly for the S&P/ASX 200 over the past decade, while it increased in benchmarks measuring four of the world’s five largest equity markets. The S&P 500 and Canada’s S&P/TSX Composite experienced the largest increases, while the U.K. was the only top five market to see a decrease.

Examining the S&P/ASX 200 and S&P 500, we can see how the sector dynamic played out during this period. The weight of Materials and Financials declined for both indices, while Information Technology increased. However, the Information Technology sector had barely any participation in the S&P/ASX 200 10 years ago, which perhaps makes this change even more significant in Australia, given the small initial base.

In Exhibit 3, we can see how much each sector’s weight has changed over the past 10 years. While some sectors declined across all markets, such as Energy and Materials, others like Information Technology have increased—this was most notable in the U.S., with its share in the S&P 500 going up by 13%.

For the S&P/ASX 200, Materials and Financials each declined 6%, while Health Care and Information Technology increased by 7% and 4%, respectively. This is quite notable, as the sectors that have traditionally dominated the index (Financials, Materials, and Energy) accounted for 67% of the index 10 years ago, and now with the growth of Health Care, Real Estate, and Information Technology, this has lowered to 53%.

In conclusion, changes in the level of diversification varied across markets over the past decade. While the S&P/ASX 200 has become more diversified as a result of growth within newly emerging companies and sectors, growth in other markets was centered on previously large companies and sectors, which led to more concentration in the market overall.