Indexology^® Blog

U.S. dollar strength has led to parity in EUR-USD exchange rates in recent days, with the value of the euro equaling 99 U.S. pennies at its low. While 114 U.S. pennies were still required to equal the British pound sterling, “cable”—the GBP-USD rate—has reached its lowest since 1985.

In Asia, the Japanese yen has suffered the most YTD of any developed market currencies versus the U.S. dollar. Meanwhile, the Chinese yuan has surpassed 7 to the U.S. dollar, while the Brazilian real gained in contrast.

Year-to-date, the Dow Jones FXCM Dollar Index, which measures the U.S. dollar versus the most liquid currencies, was up 9.03%, capturing the general trend in U.S. dollar strength.

For U.S. investors holding equities from these markets, this means returns of these holdings have decreased when translated back into a stronger U.S. dollar, compounding the weak underlying market performance. To estimate the impact of this broad currency weakness versus the U.S. dollar, Exhibit 2 shows country index returns in both U.S. dollar and the local currency (LCL).

In aggregate, developed market indices have been most affected, with the performance relative to the local currency return decreasing by more than 11% YTD. Meanwhile, currency losses were more mitigated across emerging markets, in part due to the offsetting gains in the Brazilian real.

Exchange rate moves can have a meaningful impact on international equity performance. While recent global market performance has been weak, U.S. investors have been doubly affected by currency underperformance versus the U.S. dollar. If the current trend reverses, a weakening U.S. dollar would become additive to international equity returns for these investors.

Those who implement style investing will have noticed a recent reversal of fortunes for the value approach following a long spell of underperformance. Since the inception of the S&P/ASX 200 Growth and S&P/ASX 200 Value in 2017, the back-tested approach has seen growth top value in 12 out of the past 17 calendar years.

However, with growth peaking in Australia and broadly across developed markets in 2020 (2021 in the U.S.), the rotation toward value is well underway. The digital innovation-led market with a prolonged period of loose monetary policy has given way to high inflation—now reaching multiple decade highs and tightening monetary policies by central banks. In this environment, future company earnings are discounted more heavily, and they are exposed to higher capital and other input costs, which hinders growth.

Value outperformed growth in 2021 across the board in developed markets. In Australia, value trumped growth by more than 7% and has accelerated its resurgence in 2022, outperforming growth by over 10% YTD and by more than 20% cumulatively over the past two years (as of Aug. 31, 2022).

Over the one-year period as of Aug. 31, 2022, value exhibited resilience in a falling market, with the S&P/ASX 200 Growth (-9.19%) and the broad market S&P/ASX 200 (-3.43%) declining, while the S&P/ASX 200 Value gained 2.64%. An outperformance spread of nearly 12%.

The S&P/ASX 200 Growth and S&P/ASX 200 Value consist of companies with pure growth and value characteristics, respectively, as well as companies within the broader S&P/ASX 200 categorized as “blend.” This style bias results in two distinctive indices from companies within the S&P/ASX 200. Exhibit 4 highlights the difference in sector weights between the value and growth approaches.¹

In the current market environment, we can see significant dispersion of returns among sectors, with the one-year difference as of Aug. 31, 2022, between the highest-performing sector (Energy 53.00%) versus the worst-performing sector (Information Technology -34.75%) at 87.75%. This spread is among the highest exhibited over one-year periods going back 10 years. The past 12 months have seen the outperformance of Energy over Materials, Consumer Staples over Consumer Discretionary and Financials over Health Care, and it has resulted in considerable relative gains for the value approach over the broad market.

As expected, the correlation between the growth and value investment styles has significantly lowered compared with longer-term averages. This also rings true in global markets, with value and growth indices in the U.S., Europe and Japan displaying similar dynamics over recent months—a value-led comeback, higher sector dispersion and lower correlation following a long period of growth outperformance.

Australian investors haven’t historically been as style aware with their domestic equity exposure compared to those in the U.S. and other developed markets. Given such distinctive performance characteristics, the S&P/ASX 200 Growth and S&P/ASX 200 Value offer a unique lens through which to evaluate market dynamics compared to the broad market S&P/ASX 200.

¹ Please refer to the methodology document for S&P/ASX Indices for more information: https://www.spglobal.com/spdji/en/documents/methodologies/methodology-sp-asx-200-style.pdf.

How can indices help investors understand what’s driving market trends amid inflation, rising rates, and volatility? S&P DJI’s Anu Ganti and Hamish Preston take a closer look at key trends and  what they could mean for active management and asset allocation moving forward.

Canadian equities continued their decline, losing another 8.76% (through September 15, 2022) since the last rebalance of the S&P/TSX Low Volatility Index on June 17.  Characteristically for a falling market, Low Volatility outperformed (by 13 basis points), declining 8.63%.

As it had done in June, volatility again increased for every sector of the S&P/TSX Composite Index. Energy, Health Care and Technology were among sectors with the biggest hike in volatility.

Despite this, the latest rebalance for the S&P/TSX Composite Low Volatility Index (effective at the close of trading on Sep. 16, 2022) either maintained or added to positions in these sectors. The index screens for the lowest volatility at the stock level, so these results suggest that there are pockets of relative stability even within higher-volatility sectors.

Financials, Real Estate and Utilities continue to be the most overweighted sectors in the Low Volatility index.

As the equity market has waned and waxed in 2022, investor interest has naturally turned toward ways of mitigating portfolio losses. Some factor indices can serve this goal, but investors searching for a defensive strategy need to define their search carefully.

It’s natural to think that defensive strategies will be less volatile than the market as a whole, and this is a useful intuition. Some factor indices, in fact, have produced lower-than-market volatility with greater-than-market return. When such indices are combined with fixed income securities, the resultant efficient frontier often dominates combinations of fixed income with a cap-weighted market index.

That said, the essential requirement of a defensive index is not that it reduce volatility, but rather that it demonstrate a particular pattern of relative performance. Defensive factor indices aim to reduce losses in a declining market while also participating in rising markets. We often summarize this by referring to the “two Ps”—protection (in down markets) and participation (in up markets), while stressing that neither P is perfect.

Importantly (and counterintuitively), defensive indices are not necessarily less volatile than the benchmark from which they are derived, as Exhibit 1 illustrates.

The hypothetical factor index in the exhibit outperformed its hypothetical benchmark, although with higher volatility. Yet it is clearly a defensive index. When the benchmark rises, the factor is more likely to underperform than to outperform, and its average value added is negative. When the benchmark declines, the factor is more likely to outperform, and its average value added is positive. It delivers, in other words, on both Ps, participating in up markets and protecting in down markets.

Defensive indices will typically be less volatile than their parents. But not always. Investors seeking a defensive profile should take care not to rely on volatility statistics alone.