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Fleeting Alpha: The Challenge of Consistent Outperformance

The Valuation of Low Volatility

Strengthening Your Core with Indices in South Africa

Conceptualizing a Paris-Aligned Climate Index for the Eurozone

S&P 500® Low Volatility Index: Five Decades of History

Fleeting Alpha: The Challenge of Consistent Outperformance

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Andrew Cairns

Director, Global Research & Design

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Berlinda Liu

Director, Multi-Asset Indices

INTRODUCTION

The phrase “past performance is no guarantee of future results” (or some variation thereof) can be found in most funds’ literature, and for good reason: a wealth of studies show a lack of long-term performance persistence among actively managed mutual funds. However, many investors appear to believe that winners persist: past performance and related metrics remain important factors in manager selection.

Since 2002, S&P Dow Jones Indices has published the SPIVA® U.S. Scorecard, measuring the percentage of active managers that beat their benchmarks across various equity and fixed income categories. Its sister report, the Persistence Scorecard, shows the likelihood that a top-quartile manager maintains its status in subsequent periods.

By marrying the two reports, this paper studies the degree to which outperforming funds from one period continue to beat their benchmarks thereafter. Specifically, we first identify funds that beat their benchmarks, based on three-year annualized returns, net-of-fees. We then examine whether these funds (the “winners”) can continue to outperform during each of the next three one-year periods.

Our results show that among equity funds that beat their benchmarks over the three-year period ending Sept. 30, 2016, the performance persistence among domestic and international equity categories in the following three years was worse (in general) than a random draw. In other words, past performance did not typically help identify superior performing managers in advance.


DATA AND METHODOLOGY

The University of Chicago’s Center for Research and Security Prices (CRSP) Survivorship-Bias-Free US Mutual Fund Database serves as the underlying data source for our study. The universe used for the study only includes actively managed domestic U.S. equity funds. Index funds, sector funds, and index-based dynamic (leveraged or inverse) funds are excluded from the sample. To avoid double counting multiple share classes, only the share class with greater assets is used. At each measurement period, the universe consists of over 2,300 active equity funds, on average (see Appendix I).

Based on the earliest availability of Lipper style classifications, our study covers the period from March 31, 2000, through Sept. 30, 2019. On a quarterly basis beginning on March 31, 2003, we compute the trailing threeyear annualized returns for each fund in our universe, as well as for their benchmarks. We then identify funds that beat their benchmarks and track their relative performance in each of the next three years. By identifying funds that beat their benchmarks as winners and those that do not as losers, this approach applies the “winner-winner, winner-loser” methodology developed by Brown and Goetzmann (1995) and examines if winners in period t are also winners in t + j, where j = Year 1, Year 2, and Year 3.

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The Valuation of Low Volatility

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Fei Mei Chan

Director, Core Product Management

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Craig Lazzara

Managing Director, Core Product Management

EXECUTIVE SUMMARY

• Low volatility strategies, as the name suggests, typically perform well when markets decline. Challenging traditional capital asset pricing theory, they have, anomalously, outperformed their benchmarks over time despite exhibiting lower risk.

• Due to their popularity in recent years, some critics have claimed that low volatility stocks are overbought and overvalued.

• We attempt to quantify the current valuation of low volatility. Moreover, we ask if it is possible to identify valuation environments during which low volatility strategies offer more bang for the buck.

• Relative valuation for the S&P 500® Low Volatility Index has gradually become more expensive since 2000; at the end of 2019, the low volatility index was modestly cheaper than its parent S&P 500. However, as a leading indicator of the relative performance of low volatility strategies, value has never been particularly valuable.

THE RISE OF LOW VOLATILITY

What is commonly referred to as the low volatility anomaly is not a recent discovery; it has been well documented in academic research for over four decades.1 Popularized in the turmoil following the 2008 financial crisis, low volatility strategies, as the name suggests, have served well in times of market distress. The anomalous aspect is that despite their lower risk, low volatility strategies have outperformed their benchmarks over time, challenging classic capital asset pricing theory that risk and reward go hand in hand. The long-term outperformance of low-risk portfolios is perhaps “the greatest anomaly in finance.”2

The S&P 500 Low Volatility Index3 is one example of such a strategy. From January 1991 to December 2019, this index delivered an average annual return of 11.28%, compared with 10.44% for the S&P 500, with less volatility (standard deviations of 11% and 14%, respectively). This same risk/return profile is consistent with history extending to the 1970s.4

In recent years, low volatility strategies have gained fortune along with fame, gathering about $130 billion in assets in more than 200 funds globally.5 Along with the generous inflows, concerns have risen around the valuation of the portfolios tracking low volatility strategies.6

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Strengthening Your Core with Indices in South Africa

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Tim Edwards

Managing Director and Global Head of Index Investment Strategy

Since the introduction of index-based investing in the 1970s, passively managed assets have grown substantially, with AUM in products tracking the S&P 500® reaching nearly USD 3 trillion.

South Africa has participated in the global trend; a wide range of indices has been developed for the region, meeting a growing demand for passive solutions that span asset classes and investment styles.  This paper highlights the range of passive exposures and indices available in South Africa and uses S&P Dow Jones Indices’ (S&P DJI) array of domestic and international indices to illustrate the variety of outcomes that could have been achieved with index-tracking portfolios, maintaining the perspective of a local investor.

Summarizing one of the key conclusions of this paper, Exhibit 1 shows the potential differences in risk and return profiles that a South African investor might have obtained over a 10-year period by making different possible choices among indices.  An allocation to international equities would have proved beneficial in most cases, but the choice of domestic equity index— the “core” exposure—proves to be an important decision point.

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Conceptualizing a Paris-Aligned Climate Index for the Eurozone

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Leonardo M. Cabrer

Director, Global Research & Design

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Ben Leale-Green

Associate Director, Research & Design, ESG Indices

On the brink of irreversible climate change, a combination of ground-breaking datasets and index innovation is emerging, through which investors will have the choice to align their investments to a future climate scenario compatible with mitigating catastrophic global warming to the planet. This new breed of sustainable climate indices will not only offer solutions that intend to be impactful, but equally aim to provide investors with reduced risks from transitioning to a low-carbon economy and the consequences of physical, environmental events while capturing financial opportunities that arise.

Based on scientific evidence around the need for a 1.5°C1 global warming scenario to be hit (Masson-Delmotte, et al., 2018), the EU Technical Expert Group (TEG) has released its final report (The EU Technical Expert Group on Sustainable Finance, 2019), outlining two new climate benchmarks. This paper describes an S&P Dow Jones Indices (S&P DJI) concept for the eurozone region, which is aligned with the more stringent of these two new climate benchmarks: the Paris-Aligned Benchmark.

The index concept uses pioneering, forward-looking Trucost datasets to meet multiple climate objectives, aligned with a 1.5°C scenario and the Task Force on Climate-related Financial Disclosures (TCFD) recommendations, while incorporating the Science Based Targets Initiatives-endorsed climate transition approaches and state-of-the-art Trucost physical risk data.

Exhibit 1: Data Inputs into the PAC Concept

Exhibit 1 outlines the inputs into the S&P Eurozone Paris-Aligned Climate Index Concept (PAC Concept), which enable the climate objectives achievement. This paper outlines how climate-related objectives can be met, due to the use of optimization, while maintaining similar performance to the underlying index, with low tracking error. This results in a broad, diversified index that should perform similarly to the underlying index. Factor analysis shows there to be unexplained alpha that may be driven by the climate strategy of the PAC Concept.

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1 Global warming should not exceed 1.5°C above pre-industrial levels. 2 A part of S&P Global.

S&P 500® Low Volatility Index: Five Decades of History

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Hamish Preston

Director, U.S. Equity Indices

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Izzy Wang

Analyst, Strategy Indices

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Phillip Brzenk

Head of Multi-Asset Indices

S&P Dow Jones Indices (S&P DJI) publishes a series of low volatility indices, offering market participants a perspective on the returns of lower volatility equities and forming the basis for index-linked products globally.1 Low volatility indices have typically outperformed their underlying broad market benchmarks on both an absolute and a risk-adjusted basis.2 S&P DJI recently extended the returns history for one of the widely followed low volatility benchmarks—the S&P 500 Low Volatility Index—back to February 1972.3 Using the additional two decades of return information, this paper:

• Offers a longer-term perspective on the ability of low volatility indices to combine downside protection and upside participation;

• Assesses the relative importance of equity market movements and interest rates in explaining the low volatility index’s performance; and

• Demonstrates the potential applications of low volatility indices.

Exhibit 1 shows the risk-adjusted returns for the S&P 500 Low Volatility Index and the S&P 500 in each decade since 1972.

Source: S&P Dow Jones Indices LLC. Chart based on daily data between Feb. 18, 1972, and Dec. 31, 2019. Risk-adjusted returns based on the ratio of annualized returns to annualized volatility. Past performance is no guarantee of future results. Chart is provided for illustrative purposes and reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with back-tested performance.

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1 Please see Appendix A for an overview of the low volatility indices offered by S&P Dow Jones Indices. 2 Chan, Fei Mei and Craig J. Lazzara, “Is the Low Volatility Anomaly Universal?,” S&P Dow Jones Indices, April 2019. 3 Previously, the returns data began in November 1990.

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