In This List

A Fundamental Look at S&P 500 Dividend Aristocrats®

Constructing a Systematic Asset Allocation Strategy: The S&P Dynamic Tactical Allocation Index

A Glimpse of the Future: India's Potential in Passive Investing

A Performance Analysis of Variable Annuities With Risk Control

The Value of Research: Skill, Capacity, and Opportunity

A Fundamental Look at S&P 500 Dividend Aristocrats®

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Smita Chirputkar

Director, Global Research & Design

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Aye Soe

Managing Director, Global Head of Product Management

EXECUTIVE SUMMARY

  • Dividends play an important role in generating equity total return. Since 1926, dividends have contributed approximately one-third of total return for the S&P 500®, while capital appreciations have contributed two-thirds. Therefore, sustainable dividend income and capital appreciation potential are important factors for total return expectations.
  • Companies use stable and increasing dividends as a signal of confidence in their firm’s prospects, while market participants consider such track records as a sign of corporate maturity and balance sheet strength.
  • The S&P 500 Dividend Aristocrats is designed to measure the performance of S&P 500 constituents that have followed a policy of increasing dividends every year for at least 25 consecutive years.
  • The S&P 500 Dividend Aristocrats exhibits both capital growth and dividend income characteristics, as opposed to other strategies that are pure yield or pure capital-appreciation oriented.
  • Across all of the time horizons measured, the S&P 500 Dividend Aristocrats exhibited higher returns with lower volatility compared with the S&P 500, resulting in higher Sharpe ratios.
  • As of the December 2018 index rebalancing, S&P 500 Dividend Aristocrats constituents included 57 securities, diversified across 11 sectors.
    • The constituents have both growth and value characteristics.
    • The index has a significantly higher percentage of high-quality stocks (ranking ‘A-’ or higher) than the S&P 500.
  • The composition of the S&P 500 Dividend Aristocrats contrasts with that of traditional dividend-oriented benchmarks that have a steep value bias and have high exposure to the financials and utilities sectors. At each rebalancing, a 30% sector cap is imposed to ensure sector diversification.
  • The S&P 500 Dividend Aristocrats follows an equal weight methodology.
    • This treats each company as a distinct entity, regardless of size.
    • This also eliminates single stock concentration risk.


INTRODUCTION

Dividends have interested market participants and theorists since the origins of modern financial theory. As such, many researchers have investigated the various topics related to dividends and dividend-paying firms. Previous studies by S&P Dow Jones Indices have shown that over a long-term investment horizon, dividend-paying constituents of the S&P 500 have outperformed the non-dividend payers and the overall broad market on a risk-adjusted basis.

In recent years, the increasing amount of academic and practitioner research demonstrates that dividend yield is a compensated risk factor and has historically earned excess returns over a market-cap-weighted benchmark. When combined with other factors such as volatility, quality, momentum, value, and size, dividend yield strategies can potentially offer exposure to systematic sources of return.

In this paper, we show that dividend yield is an important component of total return. We also highlight pertinent characteristics of the S&P 500 Dividend Aristocrats, an index that seeks to measure the performance of the S&P 500 constituents that have increased their dividend payouts for 25 consecutive years. We show that the S&P 500 Dividend Aristocrats possesses desirable risk/return characteristics, offering higher risk-adjusted returns and downside protection than the broad-based benchmark. In addition, our analysis shows that the S&P 500 Dividend Aristocrats is sector diversified and displays growth and value characteristics.

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Constructing a Systematic Asset Allocation Strategy: The S&P Dynamic Tactical Allocation Index

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Phillip Brzenk

Senior Director, Strategy Indices

SUMMARY

A typical long-term investor may seek exposure to riskier asset classes in their portfolios with the hopes of higher returns and better outcomes.  While the long-term historical returns for higher risk asset classes (such as equities, real estate, and commodities) have been higher relative to safer assets (like short-term U.S. Treasuries), losses can be substantial in downturns.  In times of distress, market participants may tactically allocate to safe haven investments, such as cash or government bonds.Nevertheless, knowing when to be fully “risk on” and when to move to safety is not an easy undertaking.

The capital asset pricing model (CAPM) assumes that investors are rational and risk averse.  However, in reality, behavior biases affect investor decision-making.  In fact, research has shown that when investor performance lags the market, it is often attributable to these biases (Elan, 2010 and Feldman, 2011).  

Behavioral biases, such as loss aversion, overconfidence, anchoring, or impulse, can lead to ill-timed or ill-advised investment decisions, resulting in less desirable outcomes (Kahneman and Ripe, 1998 and Pompian, 2018).  Investors can be hardwired to want to take action in times of volatility, whether warranted or not.  Although it can be challenging to overcome these behavioral tendencies, a systematic and dynamic allocation approach to control portfolio volatility can help prevent an unnecessary “anxious exit” from the market.

In this paper, we introduce the S&P Dynamic Tactical Allocation Index (DTAQ), which uses a systematic approach to asset allocation by incorporating dynamic and tactical investment strategies into the index design.  We first review the portfolio construction methodology, providing empirically driven rationale for the asset class building blocks and overall ruleset.  In part two of the paper, we review the historical index performance.  We compare the strategy with hypothetical static allocation versions and the classic 60/40 equity/bond portfolio.

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A Glimpse of the Future: India's Potential in Passive Investing

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Akash Jain

Associate Director, Global Research & Design

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Anu R. Ganti

Senior Director, Index Investment Strategy

EXECUTIVE SUMMARY

Fifty years ago, there were no index funds; all assets were managed actively. The subsequent shift of assets from active to passive management in U.S. and European markets may count as one of the most important developments in modern financial history. Our intent in this paper is to explore how and why this transformation took place in the U.S., why a similar transformation is beginning in India, and how India can look to the U.S. as an example of passive investing’s future growth potential.

The rise of passive management in the U.S. and Europe was the consequence of active performance shortfalls.2 In India, we observe the same shortfalls coupled with unique local factors, which can be attributed to three sources: cost, increased regulatory oversight and government initiatives, and the skewness of stock returns.

At the end of March 2018, the size of the Indian mutual fund industry was INR 21.36 trillion (approximately USD 300 billion), of which about 3.8% of assets were managed passively (see Exhibit 1).3 At this passive AUM share, a 100 bps cost differential (between active and passive) results in annual savings of INR 8 billion (approximately USD 115 million) for Indian investors and asset owners.

THE RISE OF PASSIVE MANAGEMENT IN THE U.S. AND ITS EVOLUTION IN INDIA

The U.S. has witnessed a significant growth in passive investing due to headwinds for active management in the following areas: cost, the professionalization of investment management, market efficiency, and the skewness of returns.4

Underperformance by active managers is not a new phenomenon and has been documented as early as 1932 by Alfred Cowles. It still holds true, as seen in the S&P Indices Versus Active® (SPIVA® ) U.S. Mid-Year 2018 Scorecard results (see Exhibit 2). S&P Dow Jones Indices has been the de facto scorekeeper of the ongoing active versus passive debate since the first publication of the SPIVA U.S. Scorecard in 2002. Over the years, we have expanded the scorecard’s coverage to Australia, Canada, Europe, India, Japan, Latin America, and South Africa. The results have been almost uniformly discouraging for the advocates of active management.

The evidence, over many years, is clear: a large proportion of active funds underperform their respective benchmarks over different time horizons. This is not unusual—in fact, over the history of the global SPIVA database, underperformance is far more common than outperformance.

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A Performance Analysis of Variable Annuities With Risk Control

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Alan Grissom

Managing Director, Head of Client Coverage Americas

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Hong Xie

Senior Director, Global Research & Design

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Aye Soe

Managing Director, Global Head of Product Management

EXECUTIVE SUMMARY

  • A variable annuity is a tax-deferred retirement vehicle with account values linked to the performance of underlying investment options, typically mutual funds.
  • A variable annuity with risk control framework has the added feature of providing caps and floors to the investment performance, which in turn is linked to the performance of the underlying investment options, typically a price index.
  • We construct hypothetical portfolios that allocate between a variable annuity with a risk control mechanism and a blended portfolio of stocks and bonds. Historical performance for the hypothetical portfolios with allocation to products with a risk control feature showed better downside protection than a stock portfolio or a traditional 60/40 stock/bond portfolio in some scenarios.

INTRODUCTION OF VARIABLE ANNUITIES WITH RISK CONTROL

A variable annuity is a tax-deferred retirement vehicle with account values linked to the performance of the investment options chosen by the market participant. The investment options for a variable annuity are typically mutual funds that invest in stocks, bonds, money market instruments, or some combination of the three.

A variable annuity that uses a risk control framework has the added feature of providing caps and floors to investment performance that are linked to the performance of the underlying investment options. If the underlying index delivers returns greater than the cap level or lower than the floor level, market participants will receive guaranteed payments at the cap or floor level, respectively. Therefore, variable annuities with risk control offer downside protection to investors at the expense of forgoing a degree of upside return. They offer market participants better visibility and predictability on future cash flows from annuities by effectively incorporating risk management tools in investment products.

A variable annuity with risk control features shares the same concept as and similar structure to those of risk control indices. Risk control indices are designed to measure the performance of underlying equity or futuresbased indices at specified volatility levels. As a benchmark provider of risk control indices, S&P Dow Jones Indices finds it relevant and meaningful to investigate the impact of incorporating a risk control framework into investment products, such as variable annuities, in a portfolio context.

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The Value of Research: Skill, Capacity, and Opportunity

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Anu R. Ganti

Senior Director, Index Investment Strategy

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Hamish Preston

Associate Director, U.S. Equity Indices

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Tim Edwards

Managing Director, Index Investment Strategy

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Craig Lazzara

Managing Director, Global Head of Index Investment Strategy

EXECUTIVE SUMMARY

How much should a portfolio manager be willing to pay for research?

The question is of importance to any manager, but has become particularly pertinent since newly imposed European rules require that the costs of investment research—previously offered by many investment banks as an in-kind consideration in return for brokerage business—be unbundled from trading.

Unfortunately, attempts to determine a fair value for research in the most general circumstances are doomed to fail. Even if we only consider direct recommendations to buy or sell certain securities, the value of such recommendations to a portfolio manager will vary according to the absolute size of positions taken in response. Instead, we provide a framework for estimating relative research values across markets and constituents, under certain stylized (but reasonable) assumptions.

Exhibit 1 provides a summary of our main result—comparing the putative value of recommendations in selected markets, expressed as a multiple of the equivalent measure applied to stock-based recommendations within the S&P 500® .

INTRODUCTION: THE IMPACT OF “UNBUNDLING” RESEARCH COSTS

The Markets in Financial Instruments Directive (MiFID) II is an updated version of a regulation that has been in force throughout the European Union (EU) since November 2007.1 The update came into effect on January 3, 2018, and seeks “to reform market structures, bring more transparency to the trading of financial instruments, and strengthen investor protection.”2

For our purposes, the relevant regulatory change is that execution costs and charges must be separated, or “unbundled,” from the cost of research, and that investment managers must either absorb research costs or explicitly pass them on to their clients under pre-agreed terms.3 Since investment managers were formerly allowed to pay for research by the allocation of client trading commissions, MiFID II has the potential to produce major changes in the economics of research sales.

While these rules are of most immediate concern to institutions operating in the EU, MiFID II has potential global implications: the updated directive applies to all firms that conduct business in Europe, and many expect the legislation to be extended to other regions.4,5

From a practical perspective, MiFID II requires managers to set research budgets and to decide where to spend them. Obviously, the size of a particular research budget will depend on idiosyncratic factors, such as a firm’s assets under management. But when it comes to allocating resources, the relative value of research is likely to be comparable—if I find one analyst’s recommendations to be worth double those of other analysts, it is reasonable to hypothesize that these recommendations would also prove to be twice as valuable to anyone else.

This paper argues that the relative value of research is driven by a combination of three things: the information content of the research, the dispersion within the market where recommendations are made and implemented, and the capacity of each market to allow for active positions of varying sizes. While we do not claim to offer a universally applicable framework for setting research budgets, we hope to offer a practical and useful way to think about the value of signals for markets of varying size, concentration, and risk levels.

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