Indexology^® Blog

This year marks the 30^th anniversary of the launch of indices designed to distinguish growth and value investment styles. Investment managers had classified themselves as growth or value specialists (among other possible differentiators) before 1992, but until then it wasn’t possible to evaluate a value manager against a systematically defined value benchmark or a growth manager against a growth benchmark. (Such comparisons have not generally been happy ones for active managers, but that’s a story for another day.) As with the S&P 500^®, style indices, used initially as benchmarks, also came to underlie investment products by which growth and value exposure could be indicized.

Exhibit 1 compares the performance of the S&P 500 Growth Index and the S&P 500 Value Index. When the line on the graph is rising, Growth is outperforming Value, and vice versa when the line is falling.

Growth has outperformed since 1995, although it’s obvious that leadership has shifted between the two styles periodically. Given that the last 10 years have been largely dominated by Growth, and given the historical tendency for leadership to rotate, it’s not surprising that many market participants wonder when Value will once again take the lead. It has been a frustrating wait.

I confess that I am among the frustrated. Observing that between September 2020 and May 2021 Value (up 31.6%) had outperformed Growth (up 14.2%), I brazenly suggested that perhaps the long-awaited turn had come. My temerity was rewarded by a six-month streak in which Growth outperformed Value in five months. (The final score was Growth 19.1%, Value -0.8%.)

But since the beginning of December 2021, Value has once again assumed the lead. For the last two months, S&P 500 Value has scored a total return of 5.3%, while S&P 500 Growth has lost 6.1%. As Exhibit 2 makes clear, Value has dominated Growth across the capitalization range.

Most style index series are designed so that growth and value together compose the parent index; this necessitates their holding some stocks that are not obviously in either the growth or value camp. For clients who prefer a more concentrated approach to style, the S&P 500 Pure Value Index includes only names with the highest value scores, and analogously for the S&P 500 Pure Growth Index. Historically, when Value is outperforming Growth, typically Pure Value is outperforming Pure Growth by more, and Exhibit 3 shows that this pattern has continued during Value’s recent recovery.

Of course, we don’t know how long Value’s dominance will last—the historical record has included periods as short as six months (March-August 2009) and as long as 50 months (April 2003-May 2007). Owners of value indices obviously hope for the latter outcome, but even the former leaves room for additional outperformance.

The strong inflation tailwind that supported commodities in 2021 has bled into 2022, as the S&P GSCI started the year on the front foot, up 11.6% in January. In contrast, the S&P 500^® fell 5.2% over the same period. Inflation has traditionally helped commodity markets. Commodities have also historically been a good hedge against inflation. Low inventories and robust global GDP growth, combined with continued supply bottlenecks, have been supportive for commodity prices. On the downside, tighter monetary policy (i.e., a less accommodating U.S. Fed) could strengthen the U.S. dollar and create headwinds for commodities prices as the year goes on.

The S&P GSCI Energy was up 18.4% over the month. Brent oil surged above USD 90 per barrel for the first time in seven years, as investor appetite for inflation-sensitive assets remained elevated and the market agonized over Russia-Ukraine tensions. Global oil inventories are at tank bottoms and geopolitical risks have exacerbated the current imbalance. On paper, OPEC+ is still planning to bring back 400,000 barrels per day (BPD) of production each month between now and September, but in reality, the production increases are forecast to be closer to 200-250,000 BPD each month due to underproduction and underperformance across several member countries. Global natural gas markets also continue to be roiled by geopolitical tensions. The S&P GSCI Natural Gas rallied 40.5% in January. Escalating tensions between the West and Russia over Ukraine raised concerns about Russian gas flows to Europe, prompting the European Commission and the U.S. to investigate alternative supplies.

Meanwhile, the green energy transition is not fading. Many commodities will continue to benefit from incremental demand, while other commodities, such as oil, will likely suffer from low investment. Aluminum and nickel led the S&P GSCI Industrial Metals up 2.6% over the month; both are metals that will continue to benefit from the move to more sustainable energy sources.

After 2021 showed the largest drop in six years, gold prices were down a further 1.9% in January, a relatively admirable performance compared with many other assets. The S&P GSCI Palladium was one of the best performers across the commodities complex in January, up 23.2%. Tensions between Russia and the West over Ukraine have heightened concerns over supplies of the metal used in catalytic converters.

Across the grains complex, corn and soybeans were supported by dryness concerns in South America, which has the potential to boost demand for U.S. crops later in the current crop year. Despite the fact that forecasts of global wheat supplies have risen, the risk of supplies being disrupted by the Russia-Ukraine standoff remain elevated. The S&P GSCI Agriculture ended the month 4.4% higher.

The S&P GSCI Livestock was up 1.9% over the month. A rally in lean hog prices was attributed to a slowdown in hog slaughter and robust demand in the U.S., as consumers return to the office and are eating away from home. The S&P GSCI Lean Hogs rallied 8.0% over the month.

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.