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Incorporating Environmental Considerations into Commodity Indices

Analyzing High Dividend Yield Strategies in Australia

The Case for Indexing Thematics with the S&P Kensho New Economies

Why Does the S&P 500® Matter to the U.K.?

Comparing S&P Style & Pure Style Indices

Incorporating Environmental Considerations into Commodity Indices

S&P DJI and J.P. Morgan contributed equally to this paper.

Executive Summary

The focus of the paper is on the environmental footprint of commodities and the incorporation of environmental metrics into transparent, rules-based commodity indices.

In the first section, we identify and discuss the various challenges associated with investing in commodities from a sustainability standpoint.  The focus is on environmental impacts, and while we do not specifically address social and governance considerations, we acknowledge that they are important and a key area of future research.

We then present a new dataset that measures the environmental footprint of the S&P GSCI constituents. The dataset provides robust and comprehensive physical and financial impact data on GHG emissions, water consumption and land use at the commodity level, based on life cycle impact assessment factors and natural capital valuation metrics.  We then introduce the concept of commodity valuation intensity, which ascribes an economic value to environmental impacts on a per unit of commodity production or per dollar invested (or dollar per contract value).  This allows for comparison across commodities and types of environmental impacts. We begin the process of building our index frameworks by redefining new commodity “sectors” to reflect the changing dynamics of the global economy.  We divide the components into three economic sectors: energy systems, food supply and other, based on their impact on the environmental transition and potential substitutions within each category.

The paper describes two index framework approaches to adjusting the S&P GSCI to incorporate environmental data. The first is the Optimization Approach, which seeks to reduce the environmental footprint of the index while minimizing weight and sector deviations from the S&P GSCI.  The optimized constituent weights are constrained to help maintain diversification, investability and liquidity for the index. There is also an embedded transition mechanism that seeks to decarbonize the index year-on-year. The second approach (Substitution Approach) incorporates both negative and positive environmental externalities.  Specifically, we introduce the concept of the environmental displacement ratio to measure the overall impact of those commodities that have a net positive role to play in the transition.  This approach also incorporates a glidepath to changing allocations over time and considers an allocation to carbon emission allowances.

We conclude that it is possible to build commodities indices that incorporate environmental footprint data while maintaining the similar inflation sensitivity and diversification benefits as the benchmark.  In the final section of the paper, we consider the need for additional research and discussion on the topic.

Introduction

Commodities are the building blocks of the economy.  They are essential for the provision of shelter, sustenance, warmth and light.  They are real, investable assets, and they can be highly relevant to multi-asset portfolios in relation to diversification and inflation protection.

Since the beginning of 2020, commodities markets have been trading through a period of heightened volatility, grappling with multiple sources of uncertainty, including the conflict in Ukraine, the return of high inflation, tightening monetary policy, U.S. dollar strength and the economic repercussions from COVID-19, as well as a series of supply shocks across individual commodity markets.

This volatility is based on a plethora of geopolitical issues in the short term, but longer term there are additional constraints that affect supply and demand imposed by the energy transition and the incorporation of sustainability considerations.  These market dynamics present both opportunities and challenges to those involved in the broad commodity investment ecosystem.

Sustainability considerations have become a major focus for many institutional investors.  Some asset classes such as equities and fixed income have led the way, as granular information is already available to incorporate them in to a portfolio composition.  Commodities, which play a key role in current environmental impacts and in the transition to come, have paradoxically lagged this evolution.

In this context, market participants have expressed their desire for a framework to begin to incorporate sustainability considerations into their commodity portfolios.  To date, the investing community has not grappled with this issue in regard to commodities, as much as it has with other asset classes.

The commodities market currently lacks some of the tools necessary to address this demand completely. This paper seeks to outline potential solutions for incorporating environmental considerations in commodity indices and identifying some of the remaining gaps. In doing so, we hope to not only provide market participants with considerations for their own analysis, but also help the industry identify those tools needed for further progress.

Contributors:
Fiona Boal, Managing Director, Head of Commodities and Real Assets, S&P Dow Jones Indices
Stephane Audran, Managing Director - Co-Head, Global Strategic Indices, J.P. Morgan
Steven Bullock, Managing Director, Global Head of Research and Methodology, S&P Global Sustainable1
Kimberly Gallant, Executive Director – Co-Head, Investable Index Solutions, Americas Lead, Global Markets Sustainability Center, J.P. Morgan
Adam Denny, Senior Analyst, Global Research & Design, S&P Dow Jones Indices
Gwen Yu, Executive Director – Global Markets Sustainability Center, J.P. Morgan

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Analyzing High Dividend Yield Strategies in Australia

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Jason Ye

Director, Strategy Indices

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Izzy Wang

Analyst, Strategy Indices

Introduction

Dividend indices are one of the most widely recognized factor-based strategies.  According to Morningstar, as of Sept. 30, 2022, there were 411 dividend-focused exchange-traded products (ETPs) worldwide, with over AUD 522 billion in AUM.  Dividend ETPs had inflows of over AUD 97 billion in the first three quarters of 2022.  With over AUD 3.5 billion in AUM—or 40% of the Australian factor ETP market—the dividend factor is one of the most popular in Australia.

In this paper, we will examine the Australian dividend market in depth and analyze the historical performance of the Australian high dividend yield strategy.

Australia Dividend Market

As one of the highest-yielding equity markets in the world, Australia has attracted extensive attention from market participants.  As of Dec. 31, 2022, the trailing 12-month dividend yield of the S&P/ASX 300 was 4.5%, the highest among major developed markets (see Exhibit 1).  ETF assets tracking dividend strategies in Australia have grown from AUD 571 million in 2012 to AUD 3,887 million as of Dec. 31, 2021, with an CAGR of 21% (see Exhibit 2).  In 2022, the dividend AUM fell about 8% to AUD 3,585 million.

Analyzing High Dividend Yield Strategies in Australia: Exhibit 1

Analyzing High Dividend Yield Strategies in Australia: Exhibit 2

Through the analysis of historical data, we have observed three major characteristics in the Australian dividend market:

  1. A resilient dividend pool with a stable growth rate;
  2. The financials and the materials sectors contributed the majority of dividends; and
  3. A high level of dividend yield and payout ratio.

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The Case for Indexing Thematics with the S&P Kensho New Economies

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Tim Edwards

Managing Director and Global Head of Index Investment Strategy

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Anu R. Ganti

Senior Director, Index Investment Strategy

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Srineel Jalagani

Senior Director, Strategy Indices

Offering an alternative to actively managed funds, index-based funds have played an increasingly important role in financial markets globally, particularly in the past two decades, in which 95% of all actively managed large-cap U.S. funds lagged the S&P 500®.  As indexing has grown, many passive investors have benefited substantially by saving on fees and avoiding active underperformance.  Underperformance in the world’s largest equity market can be partly explained by factors such as positive skewness of equity markets, the professionalization of investment management and cost.

However, the dynamics driving the relative performance of active funds in more narrow or specific markets, including so-called “thematic” funds, are less well understood.  In this paper, we show that similar principles apply to the thematics space as well, along with some unique challenges, using the universe of the S&P Kensho New Economies Composite Index to frame our analysis.  Underscoring the challenges of active thematic stock selection in this universe, and as Exhibit 1 illustrates, 63% of included constituents underperformed this index over the past four years.

The Case for Indexing Thematics with the S&P Kensho New Economies: Exhibit 1

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Why Does the S&P 500® Matter to the U.K.?

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Tim Edwards

Managing Director and Global Head of Index Investment Strategy

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Craig Lazzara

Managing Director, Index Investment Strategy

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Sherifa Issifu

Senior Analyst, U.S. Equity Indices

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Benedek Vörös

Director, Index Investment Strategy

Executive Summary

British equity funds tend to have less exposure to international equities than would be commensurate with the scale of the global opportunity set.  A potential under-allocation to U.S. equities, in particular, means that U.K. investors may be foregoing a potentially useful diversification opportunity.  This paper examines the S&P 500 from the perspective of a U.K.-based investor.  We examine:

-The concentration and sectoral makeup of the U.K. equity market, as well as the motivations of U.K.-based market participants to diversify internationally;

-The role of the U.K. and the U.S. in the global economy and global equity markets;

-Potentially complementary aspects of an S&P 500-linked investment for a broad-based U.K. equity portfolio denominated in British pound sterling (sterling); and

-The differences between the S&P 500 and other indices or active portfolios tracking U.S. equities.

Although this paper provides a perspective on the S&P 500 through a specific filter of an investor with an expected existing bias toward U.K. equities, many of our observations hold more generally for international investors considering U.S. equities.

Introduction

Most market participants have encountered the S&P 500; it is a widely referenced gauge of U.S. equity performance and a popular benchmark for investments.  The S&P 500 contains many of the world’s largest and most recognizable companies, with a global reach of operations, customers and revenue sources.  Further, as a consequence of an increasing popularity and scale of S&P 500-related products, including index funds, exchange-traded funds (ETFs) and listed derivatives such as futures and options, the typical cost and barriers to entry for S&P 500-linked investments have fallen over time.

For a market participant predominantly investing in U.K. equities, U.S. stocks arise in several investment contexts.  Most importantly, U.S. equities represent a significant proportion of the global opportunity set for diversification, with the S&P 500 making up 50% of the S&P Global BMI float-adjusted market capitalization.  However, Exhibit 1 illustrates that investors in U.K. equity funds have not yet taken full advantage of their diversification potential.  Specifically, Exhibit 1 shows the estimated aggregate allocations within U.K.-based equity funds to U.S. large,- mid- and small-cap equities, as compared to the relative share of each segment in the S&P Global BMI.  As of September 2022, U.K. funds had a cumulative “underweight” of 22%.

Why Does the S&P 500 Matter to the U.K.?: Exhibit 1

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Comparing S&P Style & Pure Style Indices

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Cristopher Anguiano

Senior Analyst, U.S. Equity Indices

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Phillip Brzenk

Managing Director, Global Head of Multi-Asset Indices

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Hamish Preston

Director, U.S. Equity Indices

Executive Summary

S&P Dow Jones Indices (S&P DJI) offers style and pure style indices, which categorize companies across the market cap spectrum based on their growth and value characteristics. Both sets of indices provide perspectives on the performance of value-oriented companies versus their growth-oriented counterparts, as well as forming the basis for index-linked products and benchmarks, globally.

However, the S&P Style and S&P Pure Style Indices are constructed differently, and this has important effects on their characteristics and potential applications. Updating earlier analysis, this paper:

-Explains the construction of the S&P Style and S&P Pure Style Indices;
-Compares the characteristics of both index series, including risk/return profiles, exposures to style factors and the impact of different weighting schemes; and
-Highlights the potential application of both sets of indices, including the historical benefits of taking an indexed-based approach.

Exhibit 1 shows that, on average, the pure style indices outperformed their style index counterparts in months when their respective style was in favor.

Comparing S&P Style & Pure Style Indices: Exhibit 1

Introduction

Launched in 1992, the S&P U.S. Style Indices are designed to provide broad exposure to style segments across the market cap spectrum. The indices use relevant fundamental ratios to divide the investment universe into growth and value categories. Each style category accounts for around 50% of the underlying index weight at the time of the annual reconstitution, and companies that exhibit both growth and value characteristics have their market capitalization distributed between growth and value.

Exhibit 2 shows that roughly one-third of each size segment possessed both growth and value characteristics. For example, year-end data since 2009 shows that an average of 165 securities in the S&P 500®, 131 securities in the S&P MidCap 400® and 188 securities in the S&P SmallCap 600® fell into both the growth and value indices.

Comparing S&P Style & Pure Style Indices: Exhibit 2

The S&P U.S. Style Indices' exhaustive coverage may be relevant for investors seeking broad style exposure, and the indices can help to define the broad opportunity set for active managers looking to express style views. However, the overlapping nature of the indices may not appeal to market participants that desire more precise and focused measurement tools.

Launched in 2005, the S&P Pure Style indices offer narrower exposures to style segments and they are more discerning when selecting growth- and value-oriented companies. Indeed, the pure style indices only include the most growth- and value-oriented companies, and there are no overlapping securities between the pure growth and pure value baskets (see Exhibit 3).

Exhibit 4 summarizes the rules governing the style and pure style index series. Both sets of indices use the same style descriptors—three for growth and three for value—to measure style characteristics. The choice of these descriptors was based on time series, cross-sectional and data coverage analyses on a range of style descriptors found in peer-reviewed academic literature.

Exhibit 4 also highlights the methodological differences between the two index series, including stock selection rules and weighting schemes. As we shall see in forthcoming sections, these differences led style and pure style indices to have distinct characteristics.

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