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Low Volatility: A Practitioner's Guide

Introducing the S&P U.S. Preferred Stock Low Volatility High Dividend Index

Accounting for Carbon: Sovereign Bonds

TalkingPoints: The S&P/ASX Bank Bill Index – Measuring the Australian Bank Bill Market for Short-Term Cash Solutions

Practice Essentials - Low Volatility Indexing in Canada

Low Volatility: A Practitioner's Guide

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Hamish Preston

Associate Director, U.S. Equity Indices

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Craig Lazzara

Managing Director, Global Head of Index Investment Strategy

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Tim Edwards

Managing Director, Index Investment Strategy

S&P Dow Jones Indices (S&P DJI) produces a range of low volatility indices, covering various single-country and international markets.  These indices offer a perspective on the returns of lower volatility equities and provide a basis for index-linked products and benchmarks globally.  This practitioner’s guide:  

  • Explains the construction of low volatility indices;
  • Identifies the role of broader market trends, valuations, interest rates, and sector exposures in determining their performance;
  • Highlights the potential applications of low volatility strategies; and
  • Summarizes the evidence for the existence and potential persistence of the so-called “low volatility anomaly.”

Exhibit 1 illustrates an important aspect of low volatility indices: their potential to offer higher risk-adjusted returns than the market benchmark from which they were derived.

INTRODUCTION

Basic financial theory is predicated on the idea that higher-risk investments should be priced to offer commensurately higher returns.  Unfortunately for the theory, a growing body of empirical evidence—accumulated since the 1970s[1]—suggests that, across a wide range of time horizons, geographies, and market segments,[2] stocks with lower volatility have displayed higher risk-adjusted returns.

Meeting the need for low volatility benchmarks, S&P DJI’s low volatility indices track the performance of a portfolio of the least volatile stocks selected from a given benchmark universe, such as the S&P 500.  Indeed, the first-ever low volatility index was the S&P 500 Low VolatilityIndex, launched in April 2011.  Many more have been produced since.[3] 

The performance and risk/return characteristics of these indices, both over hypothetical back tests and subsequent to their launch dates, provide further confirmation that lower-risk stocks can offer superior performance characteristics.  Exhibit 1 provides a summary for a selection of low volatility indices based on various benchmarks over the last 15 years, displaying the improved risk/return ratios of each low volatility index in comparison to its corresponding parent benchmark. 

In light of the growing popularity of products (such as ETFs) offering access to low volatility strategies, a growing body of research identifying and quantifying the drivers of low volatility performance has emerged. These include the role of sectoral allocations, interest rate sensitivities, and equity valuations.  In what follows, we shall briefly summarize the salient points that emerge from this research.

More directly to practitioners’ interests, we shall also examine the portfolio applications of low volatility strategies, in either a multi-factor or multiasset context.  We conclude by addressing the question of whether or not the so-called “low volatility anomaly” of higher risk-adjusted returns might continue.  

Note that while our results extend in spirit to many similar equity strategies, our focus will be restricted to the indices produced by S&P DJI.  Accordingly, we begin with a summary of the methodology used to construct our low volatility indices, and a brief examination of the practical consequences of using historical volatility rankings to form equity portfolios.

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Introducing the S&P U.S. Preferred Stock Low Volatility High Dividend Index

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Hong Xie

Senior Director, Global Research & Design

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Phillip Brzenk

Senior Director, Strategy Indices

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Aye Soe

Managing Director, Global Head of Product Management

INTRODUCTION TO PREFERRED STOCKS

What Are Preferred Stocks?

Preferred stocks are hybrid securities, blending characteristics of stocks and bonds.  They sit between common stocks and bonds in a company’s capital structure, thus having a higher claim on a company’s assets and earnings than common stocks, while having a lower claim than bonds (see Exhibit 1).

Like common stocks, preferred stocks represent ownership in a company and are listed as equity in a company’s balance sheet.  However, certain characteristics differentiate preferred stocks from common stocks.  First, preferred stocks provide income to investors in the form of dividend payments, typically providing higher yields than common stocks.  Second, preferred shareholders lack voting rights, resulting in less influence on corporate policy.  While common stock shares offer investors the potential for share price and dividend increases, investors generally look to preferred stocks for their high-yielding, stable dividend payments.

Preferred stocks are issued at a fixed par value, similar to bonds, with most paying a scheduled fixed dividend.  Preferred stocks are rated by independent credit rating agencies.  The rating is generally lower than bonds since preferred stocks offer fewer guarantees and have a lower claim on assets.  While a company risks defaulting if it misses a bondcoupon payment, it can withhold a preferred dividend payment without facing default risk.[1]

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Accounting for Carbon: Sovereign Bonds

INTRODUCTION

In 2015, the Paris Agreement was signed, committing 195 signatory nation-states to limiting greenhouse gas (GHG) emissions to well below 2 degrees  Celsius above pre-industrial levels.[1]  This recognized the clear role of governments around the globe in curtailing potentially catastrophic levels of global warming, which could have widespread and systemic impacts on the global economy, capital markets, and the quality of human life.  Sovereign bonds, the issuance of debt by a country to finance its activities, is one of the largest asset classes in the world, with over USD 20 trillion of central government debt securities outstanding in 2016[2] and general government debt exceeding USD 62 trillion in 2016.[3]  As such, it is a key mode of financing for governments, is one of the largest asset allocations by pension funds, and should be a focus of examination for climate risk analysis.

Portfolio carbon footprinting as a tool to support climate reporting and risk assessment has grown in popularity over recent years, so much so that it has become incorporated into best practice reporting guidelines for investors.  These include those outlined by the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD), which is backed by the central banks of the G20 countries and is legislated as part of France’s Article 173 regulation.  While it is now becoming common practice for asset owners and managers to report the footprint of their listed equity holdings and corporate fixed income portfolios, sovereign bonds have remained largely unexamined from a carbon risk and reporting perspective due to lack of appropriate metrics and actionable insight.  However, climate change affects all asset classes, so investors would need to measure, understand, and manage the climate change risks embedded in their sovereign bond portfolios as well.

In this paper, Trucost outlines a number of approaches to sovereign bond evaluation and the metrics available.  Scope and breadth of emissions are key considerations, as is the denominator chosen to normalize emissions to facilitate comparison between entities of different size.  The most appropriate metric may differ depending on the question(s) that investors intend to answer.

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TalkingPoints: The S&P/ASX Bank Bill Index – Measuring the Australian Bank Bill Market for Short-Term Cash Solutions

The S&P/ASX Bank Bill Index seeks to measure the performance of the Australian bank bill market, with maturities of up to 91 days. The series is designed for use by institutional investment managers, mutual fund managers, professional advisors, insurance companies, and custodians.

  1. How does the Australian bank bill market satisfy short-term cash balance investments?

Many financial institutions have cash balances that can be invested in short-term money market instruments.

Insurance companies have cash balances derived from:
A general account to support future claims;
An operating account used to receive premiums and pay claims; and
- A collateral or hedging account to manage funds.

Asset or fund managers and custodians need short-term investment solutions for omnibus accounts that represent cash-swept balances of client holdings. They can maximize their cash balances by investing in liquid products based on Australian bank bills. 

  1. How is the S&P/ASX Bank Bill Index constructed?

The index is based on the benchmark bank bill rates published by the ASX Benchmarks Pty Limited (ASXB). The S&P/ASX Bank Bill Index is rules based for transparency and follows a select set of eligibility criteria.

The index comprises four benchmarks and nine interpolated rates that are differentiated by the range of maturities of its constituents as follows.

The index is constructed synthetically through interpolated Bank Bill Swap (BBSW) rates, which are administered through procedures set forth by the ASXB. Detailed information on BBSW procedures can be

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Practice Essentials - Low Volatility Indexing in Canada

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Fei Mei Chan

Director, Index Investment Strategy

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Craig Lazzara

Managing Director, Global Head of Index Investment Strategy

THE LOW VOLATILITY ANOMALY

Although the low volatility anomaly was first documented more than 40 years ago,[1] the fearful and volatile market environment of the years following the 2008 financial crisis propelled the concept to the forefront of market participant interest.  In recent years, low volatility has been a hot topic in investment discourse, and this has resulted in innovative financial instruments that exploit the anomaly.  Importantly, the low volatility anomaly is not limited to one or two markets, but rather it seems to be universal.[2]

The S&P 500® Low Volatility Index is a passive vehicle that seeks to exploit this phenomenon systematically.[1]  Since 1991, the index has outperformed the S&P 500, and it has done so at a substantially lower level of volatility (see Exhibit 1).  In Canada, the performance differential between the country’s benchmark index and its low volatility counterpart is even more pronounced (see Exhibit 2).

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