Indexology^® Blog

In January 2019, we highlighted several indices designed to reduce the impact of large equity market drawdowns. Here we analyze the same suite of indices divided across three broad categories: defensive equity, multi-asset, and volatility. This analysis simply reviews performance since the S&P 500®’s high on Feb. 19, 2020, through the close on Friday, March 20, 2020.[1]

The current bear market has progressed with extraordinary rapidity—there have been only 22 trading days since the S&P 500 reached its all-time high. As such, any conclusion we draw must be considered strictly preliminary. Moreover, it’s important to begin any evaluation with a reasonable set of expectations. Defensive equity indices are, after all, still equities; we hope that they will mitigate losses in the underlying benchmarks, but they’ll still go down, perhaps substantially. Loss mitigation should increase in multi-asset indices, which are able to shift capital away from a declining equity market. Finally, indices that can take a long position in volatility might, at least in the current circumstances, be the best risk mitigators of all.

Defensive Equity

This category includes three well-known index series: the S&P Low Volatility Indices, S&P Quality Indices, and S&P Dividend Aristocrats^® Indices. These indices have attracted significant inflows, particularly in recent years, as investors have balanced their need to maintain a position in equities with concerns about an aging bull market. As of the close on Friday, March 20, 2020, two of the three were beating their benchmark, the S&P 500, despite having just come through an extraordinarily difficult week. Coming into last week, the S&P 500 Low Volatility Index had recorded meaningful outperformance but then had a particularly tough week due to overweight positions in Real Estate and Utilities, two of the hardest hit sectors.

Multi-Asset

Multi-asset indices combine imperfectly-correlated asset classes (such as stocks and bonds) with the goal of creating broadly diversified portfolios. These indices employ disciplined asset allocation rules and dynamically adjust their leverage or allocation with the aim of achieving a more stable risk profile.

As expected, many of these indices have de-leveraged or increased allocations to safe-haven assets as volatility has increased in recent weeks. Thus far, several have posted double-digit drawdowns, which is not surprising when almost all asset classes are down. However, losses have been muted and many of our indices have posted meaningful outperformance compared to equities.

Volatility

Volatility can be thought of as an asset class in its own right, which market participants can use to access uncorrelated returns, provide downside protection, and improve risk-adjusted performance. Indices in this category either invest directly in volatility or use it as an allocation signal.

As you will see in Exhibit 3, the Cboe S&P 500 Buffer Protect Index Balanced Series posted meaningful outperformance. This is due to the fact that each monthly index within this series “buffer protects” against the first 10% of losses in the S&P 500 over a set period of time. The S&P 500 Dynamic VEQTOR Index, which rebalanced in and out of cash and increased its allocation to short-term VIX^® futures as the VIX spiked, recorded positive returns, up 7.9%.

[1] For more details on these individual indices, please see: Seeking Volatility Protection Using Indices.

Since mid-February, the market has turned sharply down in response to the coronavirus pandemic. The S&P 500^® has fallen about 32% from its peak this year. Equity volatility shot up, as VIX^® went from historical lows to the 70-80 range, which was last seen in November 2008. The 10-year U.S. Treasury Bond yield reached 0.32% intraday before it bounced back above 1%, as the market expected more debt issuance with drastic fiscal measures to combat the economic slowdown. How has U.S. corporate debt weathered this market storm so far?

Exhibit 1 shows the average credit spread of the U.S. corporate bond market in the context of post-2008 global financial crisis (GFC). The recent move has put spreads at the widest since the GFC, and still much tighter than the peak level during the 2008 GFC when the investment grade spread reached over 500 bps and high yield over 2000 bps.

How did corporate bonds with different credit quality perform during this market stress? Exhibit 2 charts the spread difference between spreads of investment grade versus ‘BBB’ and ‘BB’ versus ‘B’. The widening of spreads between rating buckets has been consistent with the direction of spread widening, and the fact that the spread between ‘BB’ and ‘B’ has reached a new post-GFC high is very concerning. In fact, the weighted average price of leveraged loans dropped to 77.06 on March 19, 2020, a new low since the rally after 2009 (see Exhibit 3). Market participants may now wonder about the funding and default risk ahead.

One of the most significant characteristics of the post-financial crisis world has been the global persistence of low, or even negative, interest rates. The entire U.S. Treasury curve yielded below 1% for the first time in history on March 9, 2020, in the wake of the COVID-19 pandemic, before the long end reverted recently on fiscal stimulus reports. Investors seeking exposure to income-generating strategies may first consider extending into high-yield corporates or leveraged loans, but viable alternatives exist in other asset classes.

The traditional equity standbys of high-dividend-paying stocks and preferreds are the easiest expansion. U.S. companies have taken advantage of low interest rates to borrow extensively and return cash to shareholders through dividends and buybacks. The economic expansion of the past decade has provided a tailwind to the long-term and steady dividend payers of the S&P 500^® Dividend Aristocrats^® and the S&P High Yield Dividend Aristocrats, without sacrificing price appreciation.

Structured finance products (ABS, CLO, CDO, etc.) can offer further income diversification and higher yields. The variety of products, underlying assets, and tranches allows for specific credit exposures or risk targets. Real assets (real estate, agriculture, commodities, and infrastructure) can provide income and act as a type of hedge to other financial instruments, as the underlying returns are often driven by practical usage rather than daily market movements. REITs and MLPs generally offer the easiest exposure to a wide array of real estate properties and locales. Mortgage-backed securities potentially offer more customized exposures, although with increased refinancing and convexity risk.

When it comes to infrastructure, many indices or funds target the cyclical construction and service-oriented firms associated with infrastructure, rather than truly offering exposure to the underlying cash flows from ownership of the assets. Shaun Wurzbach (S&P DJI) and Simeon Hyman (Proshares) discussed this last month in their Index TV video Uncovering Yield with Infrastructure, addressing the ownership and yield issue in the context of the Dow Jones Brookfield Global Infrastructure Composite Index.

Income-generating volatility strategies are another possibility. Option buy-write strategies to collect premiums can offer an extra source of income, and timing the expirations to other cash flows (asset- or liability-driven) can even reduce volatility. As an overlay, this strategy also works well in conjunction with pre-existing assets (whether intended to be income generating or not), with multiple alternatives for the option leg:

• S&P 500 + ATM (CBOE S&P 500 BuyWrite Index);
• OTM premium targeting on dividend payers (S&P 500 Dividend Aristocrats Covered Call (7.2% Premium));
• An addition to volatility targeting (S&P Daily Risk Control Covered Call Series); and
• Commodities (S&P GSCI Covered Call Select).

While ski resorts in the Northern Hemisphere were hampered by a mild end of winter, the downhill we are all experiencing has introduced a level of uncertainty and volatility beyond the slopes. The week of March 9, 2020, will go down in history as a time of unprecedented challenge and change. The spread of the COVID-19 virus globally led the World Health Organization to declare a global pandemic. Across the globe, governments and businesses have postponed or cancelled business travel, conferences, flights, festivals, sporting events, and political gatherings. Couple the pandemic with an oil price war between Saudi Arabia and Russia, and you’ve got your hands full.

The total return of the S&P 500^® was down 22.9% YTD on March 12, 2020, at a value of 5,051.97, but it bounced back by 9.32% on Friday, March 13, 2020, returning -15.73% YTD. When comparing the total return equity performance to debt, investment-grade corporate bonds as measured by the S&P U.S. Investment Grade Corporate Bond Index returned -1.16% YTD, while the lower-rated S&P U.S. High Yield Corporate Bond Index was down 8.88% YTD.

For the month until March 13, 2020, the S&P 500 was down 8.13%, on a total return basis, while the S&P U.S Investment Grade Corporate Bond Index and S&P U.S. High Yield Corporate Bond Index returned -4.76% and -8.0%, respectively. Much of the return story can be found within the industry sectors of the underlying indices. The common theme among equity and fixed income sectors was the decline in energy. The S&P Global Oil Index lost 13.16% for the month as of March 13, 2020. WTI crude oil went from USD 61 per barrel on Jan. 1, 2020, to its current level of USD 30. Though the oil feud is between Saudi Arabia and Russia, the U.S. and its shale market are getting caught in the middle. U.S. shale firms announced a number of drilling and investment cuts that will negatively affect a number of energy businesses and their employees. Energy support companies that provide supplies, machinery, and exploration services will all be caught up in this downturn.

Exhibit 3 shows the option-adjusted spread (OAS) and the change in OAS year-to-date for each of the industry sectors for the S&P U.S. Investment Grade Corporate Bond Index and the S&P U.S. High Yield Corporate Bond Index. All 11 GICS^® sectors for both indices widened out, resulting in higher yields and lower prices. The energy sector again clearly stands out among the sector comparison.

As the economy continues to suffer at the hands of the pandemic and oil shocks, fears of a recession increase with each day. The cancelling and postponing of global events should help curtail the spread of the virus, but the aftereffects experienced by small businesses, restaurants, retail, and employment will likely have a damaging effect for the foreseeable future.

On February 19^th, the S&P 500® closed at an all-time high of 3386; last night, exactly one month later it closed at 2409, a 29% decline from the high.  Let’s take a moment to reflect on what’s happened over the last month.

We should first start by putting the decline into historical context. The peak-to-trough decline in the Dow Jones Industrial Average was 33%, comparable to its slide during the bursting of the Tech bubble from 2000 to 2001.  We are still off from the 54% decline in the Global Financial Crisis in 2008, and would need an even steeper drop to put this recent crisis on par with the Great Depression’s 89% market decline.  The unusual aspect of the current selloff has been its speed; the previous declines happened over multiple months and years; this recent drop happened in less than a month, with some days of trading echoing the extraordinary events of 1987.

Broadly, global equities have plummeted across the board.   Almost every major market is down more than 20% over the period.  China, which didn’t have quite the same run-up in early 2020 due to the coronavirus’ early spread there, offers a rare exception.

The S&P Global BMI is down 31% over the last month, wiping $19T off the market cap.  Central banks and governments have stepped in to help soften the blow, announcing both monetary (interest rate cuts, QE) and fiscal (bailouts, cash to citizens) measures.  While the ink is not yet dry, there have been a number of major commitments from central banks and governments, adding up to around $7.6T in total stimulus globally (and more to come).  Here’s our estimate of the current extent of the so-far announced measures, in comparison to the capitalizations lost by the Global BMI’s countries.

VIX® spiked to unprecedented levels.  In a history that stretches back over 7,500 trading days to January 1990, five of the eight highest closing levels for VIX occurred during the recent panic.  Only the peaks in volatility that occurred during the 2008 financial crisis saw anything similar.  The chart below comes from my colleague Tim Edwards’ most recent blog,  in which he explains that, with VIX near 80, 5% up or down is the “new normal” for the S&P 500.

It wasn’t only volatility in equity markets that shocked us, however; volatility measures spiked across nearly all asset classes, particularly oil.  After Saudi Arabia’s decision to flood the market with cheap oil following a disagreement with Russia on production cuts,  the price of oil plummeted, pulling the energy sector down sharply with it.  We saw all time-highs in several of the volatility indicators supported by S&P DJI; here are their current levels, versus their levels one month ago, and their highest close in the interim.

Interest rates have also been extremely volatile.  At one point, the U.S. 10Y Treasury yield dropped as low as 0.32% but has since rebounded to 1.04%.  While it may not sound like much, those are major moves for a developed market sovereign, particularly when you consider that yields jumped back up while equity markets dropped sharply.   Today the yield curve looks very different from one month ago, though it does now more closely resemble an actual curve.

What will be perhaps most interesting will be to see how active equity managers navigated the crisis.   According to recent dispersion readings, the opportunity to outperform the market has been as high as its been in a long while, which means that it’s showtime for active managers.

Regardless of where the market goes from here, or if active managers have indeed navigated the choppy seas, the last month will likely be one we’d all like to forget.

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