IN THIS LIST

Sector Effects in the S&P 500®

Blending Factors in Mexico: The S&P/BMV Quality, Value & Growth Index

Distinguishing Style From Pure Style

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

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

Sector Effects in the S&P 500®

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Craig Lazzara

Managing Director, Core Product Management

The Role of Sectors in Risk, Pricing, and Active Returns


Sometimes, the sector composition of an equity portfolio is of primary importance. At other times, single-stock risks are more prominent. In this paper, we shall:

  • Assess the relative importance of sectors in determining the performance of the S&P 500 and its constituents;
  • Compare the potential of active strategies based on sectors to those based on single stocks;
  • Discuss the role that sector-based products can play in generating active returns; and
  • Identify periods when sector selection was particularly important.

This perspective is particularly timely; Exhibit 1 illustrates the increasing strength of sector-level effects in the S&P 500 over the past five years.

1. INTRODUCTION

Consider an active manager who has identified a certain stock in the Utilities sector1 as relatively attractive. He anticipates an excess return from a concentrated position in that stock, compared to a diversified position in the sector. However, a concentrated position in any stock is exposed not only to the specific prospects of that company, but to a sector and to the market. Which exposure is more important?

To illustrate the relative importance of sectoral and stock-level return drivers, consider that the average annualized dispersion of constituent returns in the S&P 500 Utilities sector over the 10 years ending in December 2018 was 10%. Thus, a better-performing stock in the Utilities sector might be expected to offer a one-year excess return over its sector of around 10%. However, over the same 10-year period, the average difference between the one-year return of the S&P 500 Utilities and S&P 500 indices was also 10%. In other words, a stock being one of the best Utilities stocks may be less important than being a Utilities stock.

Of course, even if a chosen stock outperforms its sector, and even if that sector doesn’t significantly underperform the market, the risk of a loss remains. (The S&P 500 Utilities outperformed the S&P 500 by 18% in 2008, but even the best-performing Utilities stock still had a negative total return for the year.) A manager selecting which securities to avoid faces equal and opposite difficulties; an Energy stock with poor prospects relative to its competitors might soar in price if there were a sudden shortage of crude oil.

The extent to which sector-level effects can drive stock returns is the subject of Exhibit 2. It shows the average statistical coefficient of determination (R-squared) between the daily price changes in S&P 500 constituents and their respective sectoral index, based on capitalizationweighted averages of monthly calculations over the 15-year period from January 2004 to December 2018.

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Blending Factors in Mexico: The S&P/BMV Quality, Value & Growth Index

EXECUTIVE SUMMARY

As factor-based investing gains momentum, many market participants are increasingly moving beyond single factors and are constructing multi-factor portfolios.  This progression is not surprising given that combining factors that have low or negative correlation can potentially result in a more diversified portfolio. 

However, one should note that different factors have varying performance patterns depending on market conditions, economic cycles, or investor sentiment.[1]  While every factor strategy aims to earn higher risk-adjusted returns than the broad market over a long-term investment horizon, factors can go through long periods of underperformance. 

Therefore, factor-based investing involves the potential for relative underperformance.  At the same time, timing factors dynamically is difficult to implement and can be costly.[1]  Therefore, the appeal of a multi-factor strategy lies in its ability to provide potentially smoother risk/return patterns than single-factor strategies, while addressing the issue of choosing between factors.

In light of this rationale, S&P Dow Jones Indices (S&P DJI) launched the S&P/BMV Quality, Value & Growth Index in August 2017.  The index is designed to measure the performance of securities in the S&P/BMV IPC that exhibit high quality, value, and growth characteristics.  In this paper, we introduce the performance of those factors, our rationale for combining them, the index construction, and the methodology behind the index.  

Before diving deeper into the multi-factor strategy, it is important to understand the evolution of the implementation of factor strategies in passive investing.  Factor strategies such as value, quality, and growth have existed for decades and have been utilized by active management as part of the security selection and the investment processes.  Passive offerings of factor strategies began with the introduction of growth and value investment styles and later extended to factors such as quality, momentum, and low volatility.

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Distinguishing Style From Pure Style

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Phillip Brzenk

Head of Multi-Asset Indices

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Aye Soe

Managing Director, Global Head of Core and Multi-Asset Product Management

EXECUTIVE SUMMARY

  • The first-generation S&P Style Indices cover broad market segments, grouped into value and growth categories using style metrics commonly used in the investment community. This makes the indices relevant benchmarks for evaluating the skill of active Director managers, as well as making them suitable for those seeking a traditional “buy-and-hold” index-linked investment implementation with a tilt toward a particular style.
  • In contrast, the S&P Pure Style Indices have a stricter definition of value and growth style factors, leading each to have concentrated exposures.  Unlike the standard style indices, there are no overlapping securities between pure growth and pure value, potentially presenting them as better candidates for market participants looking to have precise tools in their investment process.
  • Driven by methodological differences, the indices have distinct risk/return characteristics and behave differently in different style cycles. Over the long-term investment horizon, the pure style indices have exhibited greater returns and volatility, lower cross correlations, and wider return spreads than the standard style indices.

INTRODUCTION

Launched in 1992, the first-generation S&P U.S. Style Indices brought broad style benchmarks for large-, mid-, and small-cap equities.  The indices group the investment universe into value and growth categories, based on relevant fundamental ratios for each style.  Certain securities may exhibit both growth and value characteristics; in this scenario, the company’s market capitalization is distributed between growth and value.

As a result, there are overlapping securities that fall into both growth and value indices.  Our analysis shows that over the past 10 years, on average, 166 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 (see Exhibit 1).

Hence, roughly one-third of each size segment exhibits neither strong growth nor value characteristics.  Therefore, even though traditional style indices serve as investment universes and define the broad opportunity set for style equity managers, the overlapping nature of the indices may not appeal to market participants that desire more precise and focused measurements tools.

In 2005, S&P Dow Jones Indices introduced a second generation of style indices, the S&P Pure Style Indices, which require higher style scores for inclusion, resulting in clearer differentiation between growth and value.  The pure style indices include only securities that exhibit either pure growth or pure value characteristics.  Due to this, there are no overlapping securities between the pure style indices (see Exhibit 2).

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

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Phillip Brzenk

Head of Multi-Asset 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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Anu R. Ganti

Senior Director, Index Investment Strategy

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Akash Jain

Director, Global Research & Design

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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