Indexology^® Blog

We have made it through the first half of 2020. Despite the continued spread of COVID-19 wreaking havoc on public health and the global economy, the markets did surprisingly well during Q2. In the U.S., the equity market rebounded from Q1, driven by government stimulus packages and the easing of restrictions imposed during the pandemic. The S&P 500^® gained 20.5%, while the S&P Latin America 40, which is designed to measure the 40 largest, most liquid companies in the region, followed close behind, gaining 19.5%. However, Latin America was still deep in the red YTD, down 35.9%.

Among S&P Latin America BMI sectors, Information Technology (63.2%), Consumer Discretionary (47.6%), and Energy (41.2%) were the best performers for the quarter. In this new era of working, shopping, and recreation from home, online-based companies like Brazil’s PagSeguro Digital and StoneCo Ltd, which help businesses manage their e-commerce services, seem to be booming in emerging markets, as shown by their price appreciation. It will be interesting to see how industries quickly adapt to the “new normal” and not only survive, but also thrive.

In terms of countries, Argentina led the pack with the S&P MERVAL Index gaining 58.7% in local currency for the quarter. Brazil came in second, with a return of 31.2% as reflected by the S&P Brazil BMI. Peru’s S&P/BVL Peru General Index returned 16.7%. Chile’s S&P IPSA also had a strong quarter, with a gain of 13.5%. Colombia barely stayed afloat, with a lower return of 1.4% for the S&P Colombia BMI. Year-to-date, the countries’ returns were still in the red, with Colombia the worst and Argentina at the top with single-digit negative returns. There is still a lot of work ahead before the region stabilizes. Pre-pandemic, there were already significant domestic troubles: social unrest in Chile, economic woes in Argentina, and political instability in Brazil, among other issues. Added to this mix, the pandemic of the century and the economic damage it is leaving behind will likely make for a tough recovery.

Despite the strong quarterly returns, many economists[1] (not surprisingly) are predicting an uphill battle for the region. As the COVID-19 pandemic spreads and conditions worsen in several countries, S&P Global Ratings economists are reducing the 2020 GDP growth forecast to a contraction of roughly 7.5%. Growth for 2021 is expected to be around 4% and economic recoveries are expected to be slower than originally predicted. To put it in context, GDP for the U.S. is forecast to grow 4.8% for 2021.[2] S&P Global Ratings expectations are that economies that implemented strong policy support, such as Chile and Peru, may have “smaller permanent GDP losses.” It adds that the story may be different in countries like Mexico and Brazil, where support has been more limited.

In this environment of uncertainty, it is interesting to see how some specialized indices have performed. The following charts show the performance for the quarter and YTD of the sustainability and ESG indices for Chile, Mexico, and the Pacific Alliance, compared to the local broad benchmark and flagship index.

It is worth noting that the Dow Jones Sustainability Indices (DJSI), like the ones for Chile and the Pacific Alliance, have a different methodology than other ESG indices, as is the case of the S&P/BMV Total Mexico ESG Index. The main difference is that the DJSI series uses the “best-in-class” approach selecting a small percentage of companies with the highest scores within their respective industries. The ESG index also focuses on companies with the highest ESG scores, however, it has a broader scope in coverage, aiming to maintain low tracking error compared to its benchmark. It also applies certain exclusions in order to align with the basic principles of sustainability. Regardless, the data shows that sustainability indices have either outperformed, as in the case of Mexico, or have performed in line with their respective country indices.

A group that is having a resurgence around the world in the midst of COVID-19 is the small-cap segment. The report shows that small-cap indices (such as Brazil’s S&P/B3 SmallCap Select Index) had a great quarter (29.1%) and stable one-year return (3.4%). Likewise, Mexico’s S&P/BMV IRT SmallCap gained 24.1% for Q2 and 0.8% for the one-year period. Chile’s S&P/CLX IGPA SmallCap hung on to its five-year return (5.6%), not a small feat given that for these comparable periods, all other indices’ were far behind it.

There is no doubt that it has been a tough year, but where there is chaos, there is opportunity. Let us find it.

For more information on how Latin American benchmarks performed in Q2 2020, read our latest Latin America Scorecard.

[1] Latin American Economies Are Last in and Last out of the Pandemic. S&P Global Ratings. Elijah Oliveros-Rosen. June 30, 2020.

[2] U.S. Economic Outlook. FocusEconomics June 2, 2020. https://www.focus-economics.com/countries/united-states.

As a potential investor, would you be impressed by the pattern of fund returns summarized in Exhibit 1?  (I would be.)

Exhibit 1. Portfolio and Benchmark Cumulative Returns

Over the course of 15 years, the portfolio in question notched a total return of 69%, versus only 50% for its benchmark.  The accumulation of added value seems reasonably steady, and the portfolio doesn’t appear to be substantially more volatile than the benchmark, an impression that’s confirmed by the annual data in Exhibit 2.

Exhibit 2. Portfolio and Benchmark Annual Returns

The portfolio generated 0.62 units of return for every unit of volatility, while the benchmark’s return/risk ratio was 0.53.  Not only did the portfolio outperform in absolute terms, in other words, it also outperformed after adjustment for risk.

One of your colleagues is as impressed as you are with value added shown by Exhibits 1 and 2.  He’s so impressed, in fact, that he prepares Exhibit 3, the better to admire the accumulation of alpha.

Exhibit 3. Portfolio’s Cumulative Value Added

If we pull on this thread, the fabric begins to unravel.  The cumulative value added shown in Exhibit 3 – roughly 19% – is consistent with the total returns we observed in Exhibit 1.  But now it becomes clear that the majority of the value added came very early in our 15-year history.  What’s going on?  Exhibit 4 illuminates the issue by showing annual, rather than cumulative, value added.

Exhibit 4. Annual Value Added

For the first three years, the portfolio handily outperformed its benchmark.  For the subsequent twelve years, its value added was exactly zero – positive 50 basis points one year and negative 50 basis points the next.  After year three, the portfolio and the benchmark rose by almost exactly the same amount.  Although no new value added was generated, the initial margin is algebraically certain to increase as long as the market goes up.

As with many things in performance accounting and fund marketing, data can be accurate and misleading at the same time.  Exhibit 1, though accurate, gives the impression that the portfolio’s managers have added value steadily for the last 15 years.  Exhibit 4 reveals that their value-adding days ended more than a decade ago.  As we’ve advised before, whenever you examine a performance history, disaggregate.  If the value added is real, it will show up in annual or quarterly numbers.  If it’s not real, it might still appear in cumulative returns.  Users of more granular data are less likely to be misled.

Our latest S&P STRIDE dashboard showed a dramatic increase in the cost of retirement income for various retirement dates (vintages) in Q2.  For example, the present value of an inflation-adjusted stream of cash flows equal to USD 1 per year – or USD 1/12 per month – starting in 2065 and ending 25 years later, rose 19.07% since March.  This increase nearly matched the S&P Composite 1500’s 20.8% quarterly gain.

Even more striking was the fact that the cost of retirement income rose above USD 25 for most vintages, the first time any such measure recorded a quarter-end reading above USD 25 (based on data since January 2016). A key driver of this observation was negative real interest rates.

Calculating the present value of inflation-adjusted cash flows requires us to use real interest rates for discounting; “real” meaning that they account for inflation expectations.  Exhibit 2 shows the real yield curve at the end of June.  Appendix II in the S&P STRIDE index series methodology outlines the process for constructing the curve but suffice to say that it is calculated by:

• Using data from six S&P U.S. TIPS indices (1-5 years, 7-10 years, 10 years, 10-15 years, 15 years plus, 30 years) to obtain real interest rates across various maturities, and;
• Interpolating to obtain the entire real yield curve.

The yield curve is assumed to be flat for maturities that are shorter than the duration of the S&P 1-5 Year U.S. TIPS index (approx. 3 years) and longer than the duration of the S&P 30 Year U.S. TIPS index (approx. 30 years).  This means the 3-year and 30-year real interest rates are used to discount hypothetical monthly payments in the near-term and very far into the future, respectively.

Exhibit 2 shows that the entire U.S. real yield curve was negative at the end of June. Hence, the present value of each hypothetical monthly payment was greater than USD 1/12, resulting in cost of retirement income figures over USD 25 for most vintages. 2005, 2010 and 2015 offered the exceptions as the post-retirement vintages have fewer than 25 years of payments remaining.

The Fisher equation tells us that real interest rates can be approximated by the difference between nominal interest rates and inflation expectations: real interest rates rise as nominal interest rates rise or inflation expectations fall, and vice versa.  Since nominal U.S. interest rates were low and stable in Q2, negative real interest rates and the recent increases in cost of retirement income appear to reflect investors’ rising inflation expectations.

The sizeable monetary stimulus likely fueled this as economic theory tells us that, all else equal, increases in the money supply are inflationary – in theory, giving people additional money to spend drives up demand for goods, causing prices to rise.

Of course, inflation may not rise as expected: people made similar predictions following central bank intervention during the Financial Crisis. Nonetheless, since one of the main risks for retirees is not having enough inflation-adjusted retirement income to support their desired standard of living, investors may wish to consider retirement strategies that have an explicit focus on reducing the volatility of retirement income – such as the S&P STRIDE index series.  Indeed, post-retirement S&P STRIDE vintages have far higher TIPS allocations than their S&P Target Date counterparts, making them more insulated against changes in expected inflation.

To sign up for the S&P STRIDE: Cost of Retirement Income dashboard, please use this link.

Insurance companies continue to increase their ETF usage to serve a broad range of functions within their general account portfolios. Explore some of the most recent holding and transaction trends with S&P DJI’s Raghu Ramachandran and Kelsey Stokes.

Read the full reports to learn more about how insurance companies are using ETFs in their general account portfolios:

https://www.spglobal.com/spdji/en/research/article/etfs-in-insurance-general-accounts

https://www.spglobal.com/spdji/en/research/article/etf-transactions-by-us-insurers-in-q1-2020

Silver has soared since mid-March 2020, fueled by renewed industrial demand and investor appetite for alternatives to gold and government bonds. From its low in mid-March, the S&P GSCI Silver was up 65% as of July 17, 2020. The less precious metal, silver, has lagged gold’s recent multi-year increase. The more volatile precious metal has historically overshot moves in gold prices (see Exhibit 1). This can occur before or after a large move in gold, so it does not always occur with a lag. Notice the outsized move of silver from September 2008 to April 2011. Is this time different?

Over the past 20 years, silver’s monthly correlation to gold was 0.75—quite high, but not perfect. There is an important reason why silver isn’t perfectly correlated to gold. Industrial use is much higher for silver, accounting for more than 50% of demand. Investment demand for silver has risen over the past three years from a 10-year low, but it still only accounts for about half of the industrial demand. Typical industrial uses for silver include solar panels, automotive components, and medical devices. Although gradual, there has been a steady decline in the industrial use of silver over the past 10 years.

As of July 17, 2020, the S&P GSCI Silver was up 6.1% for the month, twice as strong as the S&P GSCI Gold’s return. Is this the start of a higher beta move for the less precious metal after a few years of directionless prices? It is too early to tell, and with the global pandemic still raging in many countries, the future is tenuous. The S&P GSCI Industrial Metals was also higher this month, in line with the move in silver, so this recent move could be explained by the economic optimism boosting certain metals on the back of promising COVID-19 vaccine trials.

If the last major disruptive event of the past 15 years is any indication, a bullish environment for gold typically opens the door to bullish price action for silver. Market participants diversified some of their gold holdings to silver in previous scenarios, and such flows tended to cause outsized moves in the much smaller silver market. It is important for market participants to be aware that the silver market is smaller and typically more volatile than the gold market.

S&P DJI calculates many variations of indices tracking the silver market, including inverse and leveraged indices such as the S&P GSCI Silver 2X Leveraged, which was up 12.1% for the month as of July 17, 2020, and back in positive territory YTD. Looking to commodities to diversify an investment portfolio could provide a silver lining in the second half of 2020.