IN THIS LIST

Concentration within Sectors and Its Implications for Equal Weighting

How the Proposed Consultation on GICS Structure Changes May Affect the S&P Carbon Efficient Indices

Degrees of Difficulty: Indications of Active Success

Factor Indices: A Simple Compendium

From Grass to Mass: An Index-Based Approach to Measuring Greenium in Green Bonds

Concentration within Sectors and Its Implications for Equal Weighting

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Anu R. Ganti

Senior Director, Index Investment Strategy

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Craig Lazzara

Managing Director, Core Product Management

EXECUTIVE SUMMARY

Concerns about the degree of concentration in cap-weighted indices like the S&P 500® seem to arise whenever performance is dominated by mega-cap names—as it has recently been. A simple way to measure market concentration is to add up the weight of the largest constituents in an index. Interestingly, after peaks in concentration—such as the aftermath of the technology bubble—the S&P 500 Equal Weight Index has typically outperformed its cap-weighted counterpart.

In this paper, we propose an alternative way to measure concentration. By adjusting the Herfindahl-Hirschman Index (HHI) to account for the number of names in a sector, we’re able to make meaningful cross-sector comparisons. We show that concentration tends to mean-revert in most sectors, which has important implications for the relative performance of equal weighting. Exhibit 1 shows recent and average adjusted HHI levels across S&P 500 sectors.

Exhibit 1: Current and Average Adjusted HHI for S&P 500 GICS® Sectors

A DIFFERENT WAY TO MEASURE CONCENTRATION

While looking at the weight of the top names is a simple way to assess market concentration, it’s useful to have a more comprehensive method
that incorporates all the constituents in an index. The HHI is a widely used concentration measure; it is defined as the sum of the squared index constituents' percentage weights. For example, the HHI for an equally weighted 50-stock portfolio is 200 (50 x 22). The HHI for the S&P 500 Equal Weight Index, which comprises 500 stocks, is 20 (500 x 0.22).

Previous research has shown that the long-term performance advantage of equal weight over cap-weighted strategies is driven more by equal weighting within sectors than by equal weight's differential weighting across sectors. This may occur because of unique regulatory challenges faced by the largest stocks in each sector; interestingly, the HHI is used by the U.S. Department of Justice in evaluating the competitiveness of markets and in making decisions on antitrust concerns.

Other things equal, a higher HHI indicates increased concentration, but other things may not be equal: even for completely unconcentrated equal weight portfolios, the HHI value is inversely related to the number of names. As seen above, an equally weighted 50-stock index has a higher HHI than an equally weighted 500-stock index. If we want to use the HHI to examine the history of concentration within an index, we need to adjust for the number of names. We therefore define the adjusted HHI as the index’s HHI divided by the HHI of an equally weighted portfolio with the same number of stocks. If there are n stocks in an index, the HHI for an equal-weighted portfolio is always (10,000/n). Therefore, the adjustment factor for an n-stock index is (n/10,000).

A higher adjusted HHI means that an index is becoming more concentrated, independent of the number of stocks it contains. We observe in Exhibit 2 that the adjusted HHI for the Energy sector decreased from 2014 to 2019, in spite of an increase in its raw HHI. This is because the number of constituents in the sector decreased from 43 in 2014 to 28 in 2019.

Exhibit 2: Historical Adjusted and Raw HHI for S&P 500 Energy Sector

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How the Proposed Consultation on GICS Structure Changes May Affect the S&P Carbon Efficient Indices

As of Oct. 18, 2021, S&P Dow Jones Indices (S&P DJI) and MSCI Inc. (MSCI) decided to consult with members of the investment community on potential changes to the GICS structure, which will likely be announced in March 2022 and become effective in March 2023. The review was intended to ensure that the GICS structure is reflective of today’s markets and continues to be an accurate and complete industry framework.  The consultation began on Oct. 18, 2021, and ends on Feb. 18, 2022. Exhibit 1 summaries the topics for the GICS Change Consultation.

Summary of Topics for the GICS Change Consultation

This analysis has been prepared by the Index Research & Design team of S&P Dow Jones Indices LLC (“S&P DJI”).  S&P DJI maintains an organizational/operating structure that separates commercial functions from analytical functions.  As such, the Research & Development team will not have access to any final changes that may arise out of the GICS Change Consultation until that information is made publicly available.

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Degrees of Difficulty: Indications of Active Success

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Fei Mei Chan

Director, Core Product Management

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Craig Lazzara

Managing Director, Core Product Management

EXECUTIVE SUMMARY

• Strong theoretical arguments and extensive empirical data support the view that we should expect most active managers to underperform most of the time. But most of the time is not all of the time, and most active managers are not all active managers. So it is reasonable to ask whether active performance tends to wax and wane.

• We examined fund performance in various market environments to see whether certain conditions correlate with better active performance. We found that active managers were particularly challenged in periods when dispersion was low, stock prices rose, and market leadership came from extremely large stocks.

• Active managers seemed to perform less poorly in years when the low volatility factor underperformed. This suggests that managers, as a group, have a tilt against low volatility stocks.

INTRODUCTION: PASSIVE VERSUS ACTIVE

The debate between passive and active investing has a long history, but in recent years it has escalated to the forefront of investor awareness. A summary of the arguments advanced by the advocates of passive investing would include the following.

• Alfred Cowles’ (1932) paper on the unimpressive predictive power of stock market forecasters1

• William Sharpe’s introduction of the Capital Asset Pricing Model (1964)2 and Eugene Fama’s random walk hypothesis (1965),3 providing a theoretical underpinning for owning the market portfolio rather than relying on active stock selection

• Pleas from Burton Malkiel (1973)4 and Paul Samuelson (1974)5 that someone (anyone!) launch a prototype capitalization-weighted index fund

• Charles Ellis’ (1975) argument that the professionalization of the investment management business made consistent outperformance unlikely6

• Sharpe’s (1991) simple demonstration that “after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.” 7

In addition, numerous observers, prominently including our own firm, have followed in Cowles’ footsteps in accumulating empirical data on the performance of active managers.8 The results confirm what theory predicts: most active managers underperform most of the time.

However, while active managers as a group cannot outperform, there is no theology to say that individual managers cannot outperform, or do so consistently.9 Even if we expect that more than half of active managers will typically underperform, theory does not tell us whether the underperformers will be 51% or 91% of the total. It is reasonable to ask if there are some market conditions that are conducive to relatively favorable (or, more precisely, relatively less unfavorable) active results.

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Factor Indices: A Simple Compendium

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Fei Mei Chan

Director, Core Product Management

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Phillip Brzenk

Head of Multi-Asset Indices

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Melody Duan

Senior Analyst, Multi-Asset Indices

S&P Dow Jones Indices

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Anu R. Ganti

Senior Director, Index Investment Strategy

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Craig Lazzara

Managing Director, Core Product Management

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Rupert Watts

Senior Director, Strategy Indices

INTRODUCTION

Passive management has become so prominent in the investing landscape that we sometimes forget that the entire history of index funds spans only 50 years. Indices, of course, have a more extensive pedigree than index funds, having been developed initially simply as a means of summarizing the returns of a given stock market. As such, it was natural for at least some observers to compare the returns of actively managed portfolios to index returns, thus using indices as benchmarks for portfolio management.  It was the observation that many (nay, most) professional investment managers routinely underperformed index benchmarks that led to the creation of the first index funds, i.e., to the use of indices as investment vehicles.

The first generation of index funds was designed to replicate an asset class; for example, the S&P 500® is the most common representative of large-capitalization U.S. stocks.  But not all active managers can be usefully evaluated by comparing them to large-capitalization U.S. stocks; specialist mandates (perhaps emphasizing value, or small size, or low volatility) are common among investment managers, and indices have evolved in order to provide appropriate benchmarking.  Factor indices—understanding a “factor” as an attribute with which excess returns are associated—are a prime example of this trend. 

Factor indices can help the clients of specialist managers disentangle how much of the manager’s performance is attributable simply to factor exposure, and how much is attributable to the manager’s stock selection beyond the factor.  Like their first-generation counterparts, factor indices can be used as both benchmarks and investment vehicles.  In the latter use, we can speak of “indicizing” a factor or set of factors—i.e., delivering in passive form a strategy formerly available only via active management.

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From Grass to Mass: An Index-Based Approach to Measuring Greenium in Green Bonds

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Brian D. Luke

Senior Director, Head of Fixed Income Indices - Americas

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Catalina Zota

Associate Director, Fixed Income Product Management ESG

EXECUTIVE SUMMARY

  • Green bonds have historically exhibited a green premium—or "greenium"—meaning they have lower yields compared to non-green bonds with otherwise similar characteristics.
  • Rapid growth and increasing differentiation within the green bond market has led to better ways to measure greenium across global bond markets.
  • An index-based approach illustrates the level of greenium across bond markets; comparing current levels to historical ones suggests shrinking greenium in many major markets.

INTRODUCTION

Green bonds are tied to specific environmentally friendly projects of an issuer. The borrower agrees that the use of proceeds will be invested in environmentally friendly projects such as alternative clean energy, low carbon assets (e.g., green buildings, factories, or vehicles), or sustainable usage of water, pollution, or natural resources. In exchange for this commitment, the issuer seeks economic benefit in the form of a lower borrowing cost. First tapped by supranational borrowers such as the European Investment Bank and the World Bank, the index market value of green bonds surpassed USD 1 trillion in September 2021, expanding from sovereign and quasi-sovereign bonds to corporate and securitized debt.

The green bond market, as measured by the S&P Green Bond Index, has grown since its 2007 debut: growth in the market value of green bonds averaged 70% annually over the past decade, compared with 3% for the global bond market (see Exhibit 1). Along with surging growth, investor demand for green bonds has remained strong.

Exhibit 1: Green Bonds across Select Markets

S&P Global Ratings' research on the European credit market observed initial sustainable bond yields to be lower compared with conventional bonds, incentivizing issuers. Despite a lower yield, or greenium, investors absorbed the liquidity of green bonds, further stimulating supply. In cases of no greenium at issuance, the research highlighted economic incentives for the investor in the form of outperformance. Tracking historical performance of two nearly identical German government bunds demonstrated additional spread tightening of 5 bps of the bund that was classified as green in the year since issuance.

Historical pricing appeared to demonstrate a price premium for green over non-green, or vanilla, bonds, as green debt represents just 2% of the overall market. More recent evidence suggests mutual benefits for investors and issuers alike as green and vanilla bond yields converge over time. This paper analyzes factors contributing to the changing relative valuation between green and vanilla bonds. Markets covered include European government agency and corporate bonds, as well as U.S. corporate and municipal markets.

Many issuers have repeatedly tapped the green bond market, allowing for issuer-based credit curves. In select cases, they provide good comparisons, but this is rare. Often, new green bonds cannibalize matured vanilla bonds, creating new issue bias. Applying a comprehensive credit valuation approach, this paper analyzes green and vanilla bonds by issuer, sector, and credit rating.

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