Indexology^® Blog

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In the last three months, the Canadian equity market climbed another three percentage points, bringing the S&P/TSX Composite Index up to an impressive 20.4% YTD through Sept. 16, 2021. In a strong bull market environment, low volatility indices are expected to lag—and they typically have. But overall, the S&P/TSX Composite Low Volatility Index has held its own, gaining 18.8% YTD, just a 1.6% shortfall.

It’s perhaps also no surprise that one-year volatility levels continue to decline (across all GICS^® sectors). Health Care remains the most volatile sector, with Information Technology close behind.

The S&P/TSX Composite Low Volatility Index seeks out the lowest volatility at the stock level, but we often look to sector volatility for insights into the dynamics that drive allocations within the index.

The latest rebalance for the S&P/TSX Composite Low Volatility Index was effective following the close of trading on Sept. 17, 2021. Changes in the index were minimal, but that’s not surprising given what we’ve seen in the sector volatility changes. Financials, Real Estate, and Utilities continue to add weight in the index and are the three largest sectors. Most of the increase came at the expense of Industrials, whose weight declined to 7% from 13%. Health Care, which represents 1% of the S&P/TSX Composite, has no weight in the low volatility index.

After exploring the characteristics and lifecycle of special purpose acquisition companies (SPACs) in our previous SPAC blog series, we will now examine the recently launched S&P U.S. SPAC Index.

The S&P U.S. SPAC Index is designed to measure the performance of a minimum of 30 common stocks of SPACs listed on U.S. exchanges. The constituents are weighted by their one-month median daily value traded (MDVT), subject to a single constituent weight cap of 15%.

As of Aug. 31, 2021, the median market capitalization of all listed SPACs was USD 270 million, much lower than the median market capitalization of USD 1.6 billion of S&P SmallCap 600^® constituents. Since most SPACs are small- or micro-cap companies, we compared the performance of the S&P U.S. SPAC Index against the S&P SmallCap 600, which is used as its benchmark. Historically, the S&P U.S. SPAC Index exhibited better risk/return characteristics than the benchmark, especially over the short- and mid-term periods. In the 45-month back-tested period ending in August 2021, the strategy exhibited a lower maximum drawdown (-26.8%) compared with the S&P SmallCap 600 (-36.1%; see Exhibit 2).

Over the period studied, the S&P U.S. SPAC Index provided downside protection in times of market turbulence. During all the months in which the benchmark was down between December 2017 and August 2021, the S&P U.S. SPAC Index outperformed 84.6% of the time and generated a monthly average excess return of 6.8% over the benchmark¹ (see Exhibit 3).

The ability to provide downside protection exists due to the structure of SPACs. IPO proceeds are held in a trust account and are invested in U.S. Treasuries while the management team is looking for the target. Thus, they have a fixed income component to provide downside protection.

Stay tuned for our upcoming research paper on SPACs!

¹ Up months: When the S&P SmallCap 600 has a positive monthly return.
Down months: When the S&P SmallCap 600 has a negative monthly return.

Active managers’ performance was disappointing in 2020, despite the market’s heightened volatility. As the market continues to march upward in 2021, it’s natural to wonder if current conditions are favorable for stock pickers.  We expect active managers’ difficulties to persist.

We can think of volatility in terms of its components: dispersion and correlation. Active managers should prefer above-average dispersion, because stock selection skill is worth more when dispersion is high. At the same time, the price of an active strategy—in terms of incremental volatility—will be relatively small when correlations are high. Both correlation and dispersion are currently below average, as we see in Exhibit 1, indicating relatively inauspicious conditions for active managers.

As a result, the required incremental return for large-cap active managers has risen as correlations have declined, which means they are giving up a greater diversification benefit. Meanwhile, lower dispersion makes it harder to add value. We see similar results for smaller-cap active managers, signaling a relatively more challenging environment for active management.

Large-cap active managers face an additional style bias hurdle. Most active portfolios are closer to equal than cap weighted, which means that they have an advantage when smaller stocks outperform. Unfortunately, Exhibit 2 shows that the largest names have recently been performance leaders.

The dominance of mega caps also hinders stock selection, as illustrated in Exhibit 3. In the first quarter of 2021, 59% of S&P 500 members beat the index, when smaller-caps were outperforming. Since then, the tide has turned, and only 34% of stocks outperformed the index, as mega caps outperformed during this period.

The current bleak environment does not bode well for active managers. We recall that 2020 was characterized by relatively favorable conditions for stock selection, and most active managers still underperformed, proving that genuine stock selection skill is rare. If these trends continue, when SPIVA results for 2021 become available, it would not be surprising if we saw lackluster active management performance once again.

On Aug. 10, 2021, the US Senate approved the much-debated Infrastructure Bill, a cornerstone of President Joe Biden’s agenda. The bill overall is worth over $1 trillion. Yet the impact on the digital asset community, while small from a dollar perspective, may be equally outsized. It is estimated that the bill will increase tax revenue collected from digital asset investors by $28 billion, not by raising tax rates or creating new taxes but rather by applying new information reporting requirements on participants in the digital asset industry.

Generally, under Section 6045 rules, those falling under the definition of a “broker” are required to issue a Form 1099 to report gross proceeds on a transaction-by-transaction basis together with their customers’ names, social security numbers, and other relevant information. The bill expands the definition of a broker to include “any person… effectuating transfers of digital assets, including any decentralized exchange (DEX) or peer-to-peer marketplace.”

This development could have a significant impact on many participants in the digital asset ecosystem, particularly within decentralized finance (DeFi), and would likely put a strain on the entire sector.

Complying with Section 6045 information reporting requirements may not prove possible for many DeFi participants as they have no visibility to the parties sending or receiving digital assets. The approved bill’s language has an extensive net, potentially covering miners, services that stake digital assets, node operators, validators, smart contracts, open source developers, hardware and software wallet manufacturers, DAO token holders, and others. This also touches individual investors who are either:

1. • Buying or selling crypto from other individuals
   • Trading crypto for crypto through a crypto exchange (or equivalent) as crypto/crypto trades are simply two transfers occurring at the same time that a broker or dealer facilitates, most often through the use of technology, or through a DEX, where there may not be an institution or any entity at all and only technology facilitating an exchange between individuals

This would effectively require affected individuals to report at the level of institutions. Transactional reporting is easily done by traditional financial institutions, where it is clear who the broker is (for example, an entity like fund manager) and who the customers are (for example, investors in fund manager’s funds).

The issue was recognized by a number of Senators, including Senators Wyden, Toomey, and Lummis, who advocated revising the language to clearly exclude miners, hardware and software wallets providers, and limit the reporting obligations to the parties who can actually report (for example, crypto exchanges).

However, the narrowed scope was determined to reduce the projected revenue by approximately $5.17 billion. Despite Senator Portman tweeting that an agreement was reached on “an amendment to clarify IRS reporting rules for crypto transactions without curbing innovation or imposing information reporting requirements on stakers, miners, or other non-brokers,” the language remained in the originally proposed form.

If the bill becomes law without narrowing down the definition of a broker it may result in overly broad application of the information reporting rules by the IRS, in turn resulting in the outflow of talent and innovation overseas as venues owned and administered by foreign persons are out of reach of US reporting rules. This could materially limit the economic benefits of the digital asset industry in the United States compared to the global economy. Since most cryptocurrencies themselves are borderless, this may not impact cryptocurrency indices overall, but rather it could affect which projects grow in the US versus ex-US.

Because the Treasury and the IRS are yet to issue any formal guidance on the taxation of digital assets, it is not unreasonable to expect at least 18-24 months of preparation time before the new rules come into effect. Currently, the law is expected to be implemented in 2023.

Tracking the performance of a selection of cryptocurrencies, including Bitcoin and Ethereum, the S&P Cryptocurrency Indices are designed to bring transparency to this evolving, unique asset class. You can learn more about S&P DJI’s digital asset solutions here.

Disclaimer:

The views and opinions of any third-party author are his/her own and may not necessarily represent the views or opinions of S&P Dow Jones Indices or any of its affiliates.