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The Value of Research: Skill, Capacity, and Opportunity

The S&P/BMV IPC Turns 40

Rotation Strategies and Their Role in the Australian Market

Earnings Revision Overlay on Fundamental Factors in Asia

Combining Low Volatility and Dividend Yield in U.S. Preferred Stocks

The Value of Research: Skill, Capacity, and Opportunity

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Tim Edwards

Managing Director and Global Head of Index Investment Strategy

S&P Dow Jones Indices

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Craig Lazzara

Managing Director, Index Investment Strategy

S&P Dow Jones Indices

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Anu R. Ganti

Senior Director, Index Investment Strategy

S&P Dow Jones Indices

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Hamish Preston

Head of U.S. Equities

S&P Dow Jones Indices

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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The S&P/BMV IPC Turns 40

A benchmark index represents the performance of a specified securities market, market segment, or asset class. The S&P/BMV IPC seeks to measure the performance of the largest and most liquid stocks listed on the Mexican Stock Exchange (Bolsa Mexicana de Valores; BMV). The index is designed to provide a representative, investable, and replicable measure of the Mexican equities market.

The S&P/BMV IPC was launched on Oct. 30, 1978, as part of a Mexican market revolution, and it has been the icon of the Mexican equity market ever since. In the middle of a long inflationary period, between the devaluation of the Mexican peso and changes in monetary policy regarding the exchange rate, 1978 was a decisive year for the Mexican economy. The country’s central bank implemented new economic and financial policies, marking a new regulatory environment that included tax exemption on capital gains, the approval of the revaluation of certain assets to support listed companies facing a delicate financial situation, and the “Mexicanization” of foreign capital through the stock exchange.1

INDEXING IN MEXICO

The need to measure the evolution of the Mexican equity market existed even before the launch of the Índice de Precios y Cotizaciones (IPC), which is now the S&P/BMV IPC. The first attempt of one of the S&P/BMV IPC’s predecessors, the Promedio de hechos de la Bolsa index from 1910, was calculated as the annual arithmetic average of the values traded by each listed company. However, this first approach was unstable due to the lack of liquidity in the market and the frequent change of listings.

Later on in 1958, the universe was restricted to 11 industrial companies, and the calculation was based on the daily average price. As the capital market grew, the sample of 11 companies became rather unrepresentative. As a result, in 1966, the sample size was changed to 30 constituents, and the calculation methodology was changed to link the average price with the previous value and to introduce adjustments for corporate actions such as splits.2

In October 1978, the BMV started the calculation of the IPC in parallel, making it public on September 1980. Over the course of the past 40 years, the index has evolved, keeping its representation and objectives aligned with the market. In this paper, we highlight the four decades of index history and major milestones, in addition to examining the characteristics of the S&P/BMV IPC as the iconic symbol of the Mexican equity market.

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Rotation Strategies and Their Role in the Australian Market

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Priscilla Luk

Managing Director, Global Research & Design, APAC

S&P Dow Jones Indices

Sector allocation is one of the main pillars in equity portfolio management. In this paper, we examine how the sector price momentum strategy and the cyclical and defensive sector rotation strategy performed in Australia based on the S&P/ASX 200 Global Industry Classification Standard (GICS®) sector indices.

EXECUTIVE SUMMARY

  • As measured by the S&P/ASX 200, the Financials and Materials sectors have accounted for 50% of the Australian market since December 1989, but since sectors can fall in and out of favor, mimicking benchmark sector weighting may not be an optimal way to maximize portfolio returns.
  • Our study on sector price momentum shows that strong momentum sectors in recent months tend to outperform in coming months, and the opposite holds for the weak momentum sectors, suggesting that sector price momentum can be exploited in sector allocation.
  • An unoptimized portfolio with quarterly allocation to the top three sectors based on 12-month price momentum generated an annualized excess return of 4.5% compared with the market between December 1989 and June 2018.
  • Cyclical sectors in Australia represented 80% of the total market, but they underperformed defensive sectors on average over the entire period studied, and they only outperformed defensive sectors in 7 of the past 28 years.
  • Our study on cyclical and defensive sector performance across global and domestic economic cycles shows the global economic cycle is a stronger driver of relative performance of cyclical versus defensive sectors than the domestic economic cycle in Australia.
  • A dynamic allocation strategy that equal weights cyclical sectors during global economic up cycles and rotates to defensive sectors during global economic down cycles achieved an excess return of 5.2% per year compared with the Australian market.

SECTOR DIVERSIFICATION IN THE AUSTRALIAN MARKET

In a previous paper, “Is There Value in Asia Ex-Japan Sector Rotation Strategies?”, we examined how sector allocation based on price momentum and economic cycles performed in Asia, excluding Japan, and we concluded that these two strategies delivered better returns than the benchmark. In this paper, we will study how these two strategies performed in the context of Australian sectors.

Our study focuses on the 11 broad sectors classified by GICS: Energy, Materials, Industrials, Consumer Discretionary, Consumer Staples, Health Care, Financials, Real Estate, Information Technology, Telecommunication Services, and Utilities. The analysis covers the period between December 1989 and June 2018. We use the S&P/ASX 200 and S&P/ASX 200 GICS sector indices to represent the Australian market and sector performances, respectively, since March 2000, which is when the S&P/ASX 200 GICS sector returns data history begins. For dates before the beginning of the S&P/ASX 200 GICS sector index return data, we use S&P Australia BMI and S&P Australia BMI GICS sector index data.

As of month-end June 2018, the S&P/ASX 200 was diversified into 11 GICS sectors, and some of these sectors can be traded through exchangetraded funds (ETFs; see Appendix for full list of S&P/ASX sector ETFs). Financials was the largest sector in the index by weight (33.1%), consisting of 26 stocks with a combined value of more than AUD 2.2 billion traded daily. Utilities was the smallest sector in the index, weighing merely 2.0% and containing five stocks with a combined value of AUD 114 million traded daily.

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Earnings Revision Overlay on Fundamental Factors in Asia

EXECUTIVE SUMMARY

In this research paper, we explore the effectiveness of overlaying earnings revision strategies on traditional fundamental value and quality factors across seven Pan Asian markets—Australia, China, Hong Kong, India, Japan, South Korea, and Taiwan—between March 31, 2006, and March 31, 2018.

HIGHLIGHTS
  • The earnings revision-screened factor portfolios outperformed their respective comparable factor portfolios across the majority of Pan Asian markets for the value and quality factors.
  • Our screening approach did not introduce a large increase in portfolio turnover or strong sector or size biases to the fundamental factor portfolios historically.
  • Among various Asian markets, the earnings revision overlay generated the most significant excess return in Australia and Hong Kong for a majority of fundamental factors.

INTRODUCTION

In our previous research paper “Do Earnings Revisions Matter in Asia?”, we concluded that stock prices tended to move in the same direction as their earnings revisions in the majority of Pan Asian markets, and the earnings revision strategies delivered excess returns in a majority of the markets.  Due to the high portfolio turnover of this strategy, using earnings revision as an overlay to fundamental factors may be more practical.  

The goal of this research is to evaluate the effectiveness of earnings revision strategies over the fundamental factor portfolios.  We overlaid two earnings revision screens (EPS change and EPS diffusion) on the fundamental value and quality factor portfolios, respectively.  Specifically, we examined if the earnings revision screens were historically effective in generating return alpha or reducing the risk of the factor portfolios by filtering out the stocks with relatively poor earnings revisions from the factor portfolios.1 

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Combining Low Volatility and Dividend Yield in U.S. Preferred Stocks

INTRODUCTION

Preferred stocks are hybrid securities that sit between common stocks and bonds in a company’s capital structure, therefore exhibiting blended characteristics of both asset classes. They have been favored by incomeseeking investors due to the higher yields they offer in comparison with common stocks and corporate bonds.

Historically, dividends have been a dominating driver for the total return of preferred stocks. Therefore, many preferred strategies seek to capture the benefit of higher-dividend-yielding preferred stocks.

However, as with any income-oriented strategy, it is important to avoid falling into a yield trap. In particular, our research in equity dividends has shown that securities in the top quintile of the yield-ranked universe have higher volatility and lower risk-adjusted returns than those in other quintiles.1 Similarly, this paper shows that higher-dividend-yielding preferred stocks also tend to exhibit higher volatility, and therefore an income strategy may require some form of volatility management for prudent portfolio construction.

Against that backdrop, we applied the low volatility factor, which is popular in equity investing, to preferred stocks. The low volatility effect refers to the finding that, historically, stocks with low volatility have tended to outperform their high volatility peers on a risk-adjusted basis. It has been extensively studied in equities by academics and practitioners alike and stock investment vehicles linked to low volatility strategies have grown significantly. Our analysis shows that the low volatility factor can be overlaid with a high-dividend strategy in preferred stocks to manage volatility while maintaining attractive yield levels.

The remainder of this paper is organized as follows. The first section explores a high-dividend investment strategy and extends the study of the low volatility effect in U.S. preferred stocks. The second section introduces the methodology of the S&P U.S. Preferred Stock Low Volatility High Dividend Index. The third and fourth sections present back-tested performance and characteristics of the index, respectively.

HIGH-DIVIDEND INVESTING AND LOW VOLATILITY EFFECT IN PREFERRED STOCKS

Preferred Stock Total Return Analysis

Preferred stocks exhibit blended characteristics of stocks and bonds. They represent ownership in companies, but they do not come with voting rights. Given their junior position to bonds in capital structure, preferred stocks generally offer higher yield than senior bonds, and higher stable dividends than common stocks, and therefore are popular instruments for incomeseeking investors.

Historically, dividend income contributes significantly to preferred stock total return. To illustrate, Exhibit 1 compares the price returns and total returns of the S&P U.S. Preferred Stock Index and S&P 500® . From its inception in 2003 until May 31, 2018, the S&P U.S. Preferred Stock Index generated a cumulative total return of 114.8%, while its price return was -22%. This is in contrast with the S&P 500, for which total return followed price return closely, and price return contributed 64% of the total return since 2003.

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