Indexology^® Blog

Commodities crushed it in 2021, with stretched supply chains a driving factor. The strong performance didn’t stop as we entered 2022. In this blog, we specifically look at crude oil and natural gas, which have outperformed the European equity market by some distance since the start of 2021 (see Exhibit 1), and what this can mean for European ESG strategies.

Given the environmentally unfriendly nature of these fossil fuel-based energy sources, it would make sense for an ESG strategy to have less exposure to energy companies. This expectation would assume an active sensitivity to both crude oil and natural gas, causing a drag on performance during times of rising oil and gas prices. Is this assumption true? Not necessarily. Since the index’s first value date, we observe no statistically significant correlation¹ between the excess return of the S&P Europe 350 ESG Index (excess of its market cap-weighted benchmark) and either natural gas or crude oil (see Exhibit 2). Simply put, there has been no significant increase or decrease in exposure to natural gas or crude oil shown by the S&P Europe 350 ESG Index, relative to its market cap-weighted benchmark.

Why the lack of increased sensitivity? It’s all about index construction (see Exhibit 3). The S&P Europe 350 ESG Index targets sector neutrality (see Exhibit 4) by removing the companies with the lowest S&P DJI ESG Scores per GICS^® industry group, after making exclusions based on undesirable ESG exposures. This means we are making exclusions on a relative basis within each industry group, rather than removing entire industry groups.

The end result? By employing S&P DJI ESG Scores and the most common ESG exclusions, the S&P Europe 350 ESG Index may fulfil the most important requirements for market participants seeking a broad, large-cap European ESG benchmark. By incorporating sustainability principles, the index could help align investments with principles while providing benchmark-like risk/return characteristics, while providing access to the broader, liquid European market. This culminates in the possibility of the S&P Europe 350 ESG Index serving as a common starting point for the growing market focused on sustainability.²

For a more in-depth look at this index, see The S&P Europe 350 ESG Index: Defining Europe’s Sustainable Core.

¹ As measured by the p-values of the Pearson rank correlation.

² The S&P Europe 350^® ESG Index: A Broad, Sustainable Index Solution (Steadman, 2022). https://www.spglobal.com/spdji/en/documents/education/education-sp-europe-350-esg-index-a-broad-sustainable-index-solution.pdf

Since the last rebalance for the S&P 500^® Low Volatility Index on Nov. 19, 2021, the market has experienced gyrations not seen since February 2021. The S&P 500 declined 6.44% since the November rebalance, with daily changes of greater than 1% almost half (44%) of the time. Low volatility strategies are designed to smooth out the path of the broader market at all times, but their work is most visible in times of stress, as shown in Exhibit 1. The S&P 500 Low Volatility Index is down just 1.28% as of Feb. 17, 2022.

Exhibit 2 shows that the volatility of the Information Technology and Consumer Discretionary sectors increased by 2% and 3%, respectively, while the volatility of the remaining sectors was either flat or down (in Energy’s case, by a whopping 9%). But the overall volatility of the S&P 500 rose from 12% to 14%. Information Technology is the largest sector in the S&P 500, as shown in Exhibit 3, and Consumer Discretionary isn’t far off, at #2; these two sectors together account for 42% of the S&P 500. So their small volatility increases, aided by a modest increase in correlations, were sufficient to raise the market’s overall volatility level.

It’s interesting to see that in the latest rebalance, effective after the market close Feb. 18, 2022, Low Volatility pared back its weight in Information Technology (unsurprisingly) but added weight (2%) in the Consumer Discretionary sector. That both sectors still have a presence in the index means that there are stocks within each sector that are still relatively stable. Energy made a reappearance for the first time in almost two years, holding a 3% weight currently. Health Care (3%) and Consumer Staples (2%) both added to their already significant presence in Low Volatility. The additions came at the expense of Industrials (-3%), Technology (-2%), Utilities (-1%), and Financials (-1%).

We’ve all heard it often—that volatility is a “feature” of Bitcoin and, by extension, the cryptocurrency market in general.

While not all of us would agree with calling it a feature, most would agree that there is a significant amount of volatility in the cryptocurrency market. And, depending on your role—trader, asset manager, advisor, observer—you may either want to capitalize on that volatility or try to reduce it.

The initial S&P Cryptocurrency Indices, as reported in our whitepaper and based on back-tested data, experienced high annualized returns for the period studied (see Exhibit 1), accompanied by significant volatility and downside risk. If we look at the S&P Bitcoin Index specifically, we can see the annualized back-tested returns are characterized by high volatility.

Using the S&P 500^® as a point of comparison, over the three-year period ending Dec. 31, 2021, the annualized return was 26%, annualized risk-adjusted return was 1.5, and annualized volatility was 17.4%.

For those looking to mitigate volatility in the cryptocurrency market, we are excited to provide a new potential index solution: the S&P Cryptocurrency Dynamic Rebalancing Risk Control 40% Indices. These indices are designed to measure a more controlled volatility and potentially smoother index returns. Risk control indices are now available for Bitcoin and Ethereum (S&P Risk Control Indices are also available for traditional asset classes—equities, commodities, and more). Exhibit 2 illustrates conceptually how risk control indices work.

For cryptocurrencies, these new indices seek to limit the volatility of the underlying S&P Cryptocurrency Indices to a target level of 40% by adjusting the exposure to the underlying index and allocating to U.S. dollars. The index is rebalanced on a dynamic basis; that is, when the 10% threshold based on exposure is crossed.

This sounds complicated, so it’s best to show the data. Exhibit 1 displays characteristics of the Bitcoin risk control index, while Exhibit 3 illustrates the performance. One can see that, while the annualized return was lower for the risk control index, the annualized volatility and drawdowns were significantly reduced. The average number of rebalances triggered per year in the back-test was 12, and the average turnover at rebalance was 13.7%. Notably, risk-adjusted return over time exceeded that of the underlying S&P Bitcoin Index.

For additional details, please refer to S&P Risk Control Indices Methodology & Parameters for current parameters and to the S&P Risk Control Indices section of the S&P DJI Index Mathematics Methodology.

For S&P DJI, this is another innovative way to bring tools and transparency to this emerging asset class.

Stay tuned for additional crypto indices launching soon!

Driven primarily by the U.S. Federal Reserve’s plan to tighten monetary policy and curb inflation, and compounded by geopolitical tensions and earnings, the S&P 500^® finished January down 5.26%.

Market participants contemplating how to position themselves for the path ahead should not overlook dividend growth strategies such as the S&P 500 Dividend Aristocrats^®. To be included in this index, companies must be members of the S&P 500 and have increased dividends for at least 25 consecutive years.

Since December 1989, the index has outperformed the S&P 500 with lower volatility.

Higher-Quality Companies

With looming inflation concerns and the prospect of further volatility, the case for dividend growth strategies may be particularly compelling. The ability to consistently grow dividends every year through different economic environments can be an indication of financial strength and discipline.

As Exhibit 2 shows, over half of the current constituents in the S&P 500 Dividend Aristocrats have grown their dividends for more than 40 years.

The defensive qualities of the S&P 500 Dividend Aristocrats can be observed by examining the historical downside capture ratio in Exhibit 3. A downside capture ratio of less than 100 indicates that a strategy has lost less than its benchmark during months when the benchmark return was negative.

Inflation Protection

Inflation is the enemy of bonds because it erodes the value of their fixed coupons. However, companies have the advantage of being able to grow their dividends to outperform inflation over the long term. Exhibit 4 shows that dividends paid by current constituents of the S&P 500 Dividend Aristocrats have grown on average by 10.6% a year over the last 25 years compared with ~2.25% per year for inflation.

Attractive Yield Potential

While potential rate hikes may make equities less attractive on a yield basis, dividends can still play an important role in generating yield if interest rates remain low on an absolute basis.

While other higher-yielding dividend strategies exist, they often come with higher risk. The S&P 500 Dividend Aristocrats, however, tend to exhibit lower risk by including only companies that have increased dividends for at least 25 consecutive years, while still delivering higher yields than the benchmark. As of year-end 2021, the S&P 500 Dividend Aristocrats had an indicative yield of 2.24% versus 1.30% for the S&P 500 (see Exhibit 5).

Risk Control

Market participants looking to further reduce risk and drawdowns may want to consider risk control strategies. These strategies dynamically adjust exposure to an index, such as the S&P 500 Dividend Aristocrats, in an effort to target a stable level of volatility in all market environments. When volatility increases, the risk control index moves out of the underlying index and into cash. The opposite occurs when volatility decreases.

Exhibit 6 shows a detailed risk/return comparison of the S&P 500 Aristocrats Daily Risk Control Indices from May 31, 1990, to Jan. 31, 2022. The three largest drawdowns were dramatically reduced across all four volatility targets.

With inflation and uncertainty in the air, dividend growth strategies offer a way to measure higher-quality companies, growing dividends, and competitive yields. Market participants looking to layer on additional protection against volatility may also want to consider risk control strategies.

In the rapidly evolving world of cryptocurrencies, one area that is getting a lot of attention is altcoins (or alternative coins). Generally, altcoins refer to cryptocurrencies other than Bitcoin. There are thousands of distinct cryptocurrencies that offer a wide variety of exposures. For instance, altcoins power decentralized finance (DeFi), infrastructure, gaming, the metaverse,¹ and more. With cryptocurrencies, it’s especially important to understand what a particular coin does, as well as its associated risks, rewards, and other features. At S&P DJI, we offer a variety of cryptocurrency indices of varying coin capitalization ranges and other characteristics.

To that end, we’re excited to announce the launch of two new indices in our cryptocurrency series—the S&P Cryptocurrency Top 5 Equal Weight Index and the S&P Cryptocurrency Top 10 Equal Weight Index. These indices are designed to measure the performance of the largest 5 and 10 cryptocurrencies by market capitalization. They also differentiate themselves with two key criteria: 1) providing substantial exposure to altcoins due to being equally weighted and 2) enhancing investability by requiring all coins to be held by at least two institutional grade custodians.

Equal-weight indices give the same exposure to each constituent, regardless of size. This is notable because Bitcoin and Ethereum dominate the marketplace with approximately 60% of total market capitalization (as of January 2022). It’s worth noting that this number has decreased from about 80% one year ago—showing both growth of the overall market and the next tier of coins. In a market-cap-weighted top 10 index, once Bitcoin and Ethereum are included, exposure would be limited for the next 8 coins. By contrast, in an equally weighted index, all constituents receive a fixed weight—10% each in a 10-coin index at each rebalance. This provides much more exposure to the next cohort of coins.

With respect to the custodian screen, we have included this to address the many challenges of cryptocurrency custody. We have touched on some of these in an earlier blog. By screening coins for custodians meeting certain criteria, we are measuring a set of coins that might have more utility for an institutional audience that may appreciate added safeguards around evolving technology—mitigating risks like hacks, lost private keys, access difficulties, etc. To that end, many banks and asset managers are integrating with digitally native third-party custodians—that is, firms created specifically to service blockchain infrastructure.

As part of the index methodology, each constituent coin must be covered by a minimum of two custodians that demonstrate both appropriate technology security (either multi-party computing [MPC] or MultiSig) and information security standards (defined by SOC II or ISO27001). Appropriate custody makes it easier for asset managers to hold and invest in the coins.

For S&P DJI, these new indices represent one more way to bring transparency to this emerging asset class. Stay tuned for additional crypto indices launching soon!

¹ “The metaverse is a digital reality that combines aspects of social media, online gaming, augmented reality (AR), virtual reality (VR), and cryptocurrencies to allow users to interact virtually. Augmented reality overlays visual elements, sound, and other sensory input onto real-world settings to enhance the user experience.” (Source: Investopedia, https://www.investopedia.com/metaverse-definition-5206578.)

S&P DJI relies on reporting from its cryptocurrency pricing provider, Lukka, Inc. for custodial screens. For more information about Lukka, please refer to the website: https://data.lukka.tech/prime/. S&P Global, Inc., the parent of S&P Dow Jones Indices LLC, is an investor in Lukka. For information on S&P Global’s investment in Lukka, please see here. In addition, representatives of Lukka may provide consultative services to the S&P Digital Assets Index Committee from time to time.

For more information on the indices, please see the methodology for the S&P Cryptocurrency Top 5 Equal Weight Index and the S&P Cryptocurrency Top 10 Equal Weight Index.