Indexology^® Blog

Research has shown that equally weighted indices have historically posted long-term outperformance¹ over their benchmarks—largely driven by their exposures to small size and value along with associated risk premia, in addition to a healthy dose of concentration reduction.² However, in accessing compensated factors and reducing concentration, the S&P 500^® Equal Weight Index could elicit some undesirable ESG consequences.

With many investors looking to integrate ESG considerations into their portfolios, is it possible to gain the benefits of equal weighting while incorporating ESG criteria? This question raises three sub-questions.

• Can ESG benefits be gained relative to the S&P 500 Equal Weight Index?
• Can factor exposures associated with equal weighting be gained within an ESG framework?
• Can we reduce concentration in a few names, while excluding companies that are undesirable from an ESG standpoint?

To give the game away early (in case you want to stop reading here): yes, yes, and yes.

Before addressing these questions, it helps to understand how the index is constructed (see Exhibit 1).

Based on this index construction, how does the S&P 500 Equal Weight ESG Leaders Select Index perform? We can see an excess return over the S&P 500 Equal Weight Index (see Exhibit 2), with comparable volatility, realizing an improved risk-adjusted return over each period examined historically (see Exhibit 3).

Can ESG benefits be gained? There were large improvements in both the S&P DJI ESG Score and carbon intensity¹ at the index level, with the S&P 500 Equal Weight ESG Leaders Select Index relative to the S&P 500 Equal Weight Index achieving a stronger ESG profile and lower carbon footprint (see Exhibit 4).

Can factor exposures be maintained?  The only significantly difference in exposure we can see is small size, as the S&P 500 Equal Weight ESG Leaders Select Index is not quite as exposed. But it still has more exposure to small size compared to the market-cap-weighted S&P 500 or S&P 500 ESG Index.

Can we reduce concentration within an ESG Framework? While there is more weight in the largest stocks in the ESG equally weighted index than in the S&P 500 Equal Weight Index, there is still a large concentration reduction from cap weighting—relative to either the S&P 500 or S&P 500 ESG Index.

Ultimately, if the factor exposures and concentration reduction of equally weighted indices with an improved ESG footprint sounds good, the S&P 500 Equal Weight ESG Leaders Select Index may be a good fit.

¹ Historical long-term outperformance was over market-cap-weighted indices.

² Rashid (2021) shows equally weighted indices have performed well during economic recovery. Bellucci & Gunzberg (2018) and Edwards, Lazzara, Preston & Pestalozzi (2018) highlight increased exposure of equal weighted indices to small size and value, while Ganti (2021) observes value exposures by equally weighted indices. Edwards, Lazzara, Preston, & Pestalozzi (2018) and Preston (2021) discuss benefits of concentration reduction.

³ We define carbon intensity as Scope 1 + Scope 2 + Scope 3 emissions/enterprise value including cash (EVIC

Explore how the design of the S&P 500 Factor Rotator Daily RC2 7% Index is helping democratize access to factor investing, providing a simple, rules-based blueprint for building dynamic factor strategies.

With the passage of the Setting Every Community Up for Retirement Enhancement Act of 2019, better known as the “SECURE Act”, and subsequent Department of Labor rules on lifetime income disclosures, the shift towards income-focused outcomes for America’s plan participants is well underway. I was reminded of the importance of this topic after watching the recent video, Closing the Retirement Gap with Indices, where Nobel Laurate Robert C. Merton and Dan Draper, CEO of S&P Dow Jones Indices, discussed the challenges facing today’s retirement system and the need for independent, transparent indices that act as a benchmark that participants can use on their journey to (and through) track their retirement investment strategies.

As highlighted by Dr. Merton’s decades work in this space, the US defined contribution (DC) system requires participants to possess investment knowledge, the time necessary to manage their asset allocation, and the ability to harmonize those allocations across the household balance sheet. Not an easy task, even for the most savvy investor. However, these challenges pale in comparison to getting the first order challenge right: identifying the correct goal for retirement.

Unlike Social Security or defined benefit plans, the DC system is focused on wealth accumulation, and unfortunately, for most, this is the wrong goal. Why? Well, most Americans today rely on their DC plan as their primary retirement funding vehicle. We use our DC savings to fund our lifestyle in retirement, from basic subsistence and health care to recreation and bequests. So, recognizing that funding retirement consumption is the goal, we must manage the unique risks that affect retirement income. In addition to the risks associated with equity investing, we also face changing interest rates and inflation in retirement: lower interest rates can reduce the income that a given balance can support, while inflation reduces the purchasing power of savings.

Now here is where getting the goal wrong may negatively impact plan participants. Most comprehensive, “do it for me” products (think target date funds) are designed with a wealth accumulation goal in mind. To mitigate the risk of not attaining that wealth goal, the allocation invests in short-term, nominal fixed income as the participant approaches retirement. This choice may work when seeking to minimize the volatility of the account balance. However, it may not be inappropriate for retirement investing, since it leaves participants exposed to inflation risk and decreasing interest rates. A more appropriate strategy – one that invests in a moderate equity allocation and an inflation-protected bond portfolio utilizing liability-driven investing – can help protect participants against market, interest rate and inflation risk. To prove this rather contrarian approach to target date fund investing, look no further than a recent SSRN paper by Mathieu Pellerin, titled Investing for Retirement Income: A Comparison of Asset Allocations and Spending Strategies. I think you will find the results compelling to say the least.

A useful resource for participants in the DC ecosystem who seek investment strategies that move from a wealth-focused mindset to the more appropriate focus on retirement income, is the benchmark or index. As an independent, transparent measurement, indices like the S&P STRIDE Index aim to provide these participants with information to benchmark the performance of their retirement goals. I applaud the application of lifecycle finance in the methodology of these indices. Further, to paraphrase Dan Draper, the S&P STRIDE Indices aim to track strategies where retirement income is sought to be the outcome. To that I say, Amen!

Disclaimer:

Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission. Dimensional Fund Advisors: (i) has collaborated with S&P Dow Jones Indices to create the S&P STRIDE Index and receives license fees with respect thereto and (ii) licenses other S&P Dow Jones Indices data and trademarks in exchange for a fee payable to S&P Dow Jones Indices.

Robert Merton provides consulting services to Dimensional Fund Advisors LP.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to their financial advisor prior to making any investment decision.

There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.

1.5°C, net zero emissions, COP, Glasgow, Paris, carbon offsets, stranded assets…
Or… as Greta might say “blah blah blah.”¹

With so much information, it’s easy to tune out to the noise of climate change.

From the heatwaves of California,² to the climate protesters in London,³ to the floods in Bangladesh,⁴ climate change is affecting everyone.

For 25 years, the U.N. has been bringing together almost every nation on Earth for global climate summits, which are known as “COPs” (Conference of the Parties). This year is the 26th annual summit—giving it the name COP26. The summit is in Glasgow, with the U.K. as host and president.⁵

COP26 will see delegates from up to 197 countries gather to detail how they will achieve the goals of the Paris Agreement⁶ to limit global warming to well below 2°C and pursue efforts to limit it to 1.5°C. This requires hitting net zero emissions by 2050, meaning the emissions produced by humankind would be balanced by emissions removal.

Committing to net zero reduction targets by 2050 may seem like a relatively easy target to agree to, given it’s almost 30 years away—but it isn’t. Long-term targets require short-term milestones. One of the key asks at this year’s COP is that countries come forward with ambitious 2030 emission reductions targets.⁷

Curbing emissions in the next 10 years inevitably means there will be widespread impacts on all of us sooner—the way we travel, live, eat—almost no aspect of our lives will be untouched.

What’s the Role of Indices?

“To achieve our climate goals, every company, every financial firm, every bank, insurer and investor will need to change.” – UN Climate Change Conference UK 2021⁸

There are many reasons for investors to align their portfolios with net zero, from concerns about climate risks in their portfolios to seeking investment opportunities. Likewise, there are many ways to align portfolios with a net zero scenario, for instance increasing exposure to companies aligned with 1.5°C or reducing exposure to the worst climate polluters. Climate investing is a complex and multi-faceted field.

At S&P DJI we have created a series of rules-based indices that are designed to select a hypothetical portfolio of companies that collectively align with a 1.5°C scenario: the S&P PACT^TM Indices (S&P Paris Aligned & Climate Transition Indices). Aligned with the ambitions of COP, these indices apply constraints for today, as well as with a 2050 outlook. There are immediate relative carbon footprint reductions of 30% or 50% relative to the benchmark, along with an ongoing requirement for the indices to decarbonize at a rate of 7% year-on-year. The indices are based on the latest climate science with the rate of annual decarbonization in line with, or beyond, the decarbonization trajectory from the IPCC’s 1.5°C scenario.

Our methodology produces broad and diverse indices while intending to meet the minimum standard for EU Climate Transition benchmarks and EU Paris-Aligned benchmarks, and it aligns with the Taskforce on Climate Related Financial Disclosures (TCFD).

Please see our dedicated Net Zero page for more information and resources.

We know why COP matters, now what actions will we take?

¹ https://www.theguardian.com/environment/2021/sep/28/blah-greta-thunberg-leaders-climate-crisis-co2-emissions

² https://www.theguardian.com/us-news/2021/sep/10/american-west-states-hottest-summer-climate-crisis

³ https://www.reuters.com/world/uk/uk-climate-protesters-face-tougher-penalties-blocking-roads-2021-10-03/

⁴ https://www.bbc.com/future/article/20201201-bangladesh-the-devastating-floods-essential-for-life

⁵ https://ukcop26.org/uk-presidency/what-is-a-cop/

⁶ https://ec.europa.eu/clima/policies/international/negotiations/paris_en

⁷ https://ukcop26.org/cop26-goals/

⁸ https://ukcop26.org/cop26-goals/finance/

The S&P SmallCap 600^® celebrated its birthday last week, marking 27 years since its launch on Oct. 28, 1994. Designed to reflect the performance of small-cap U.S. equities, the index’s cumulative total returns have been affected by trends and narratives impacting the equities segment, historically.

For example, Exhibit 1 shows that the S&P 600™ was affected by the so-called COVID-19 correction in 2020 and the subsequent rebound. The strength of the index’s rebound since Q4 2020 meant that its 59.5% total return since its last birthday was its highest figure, ever—quite the birthday present!

A key reason for the strength of the S&P 600’s rebound in the past 12 months is its greater sensitivity to U.S. macroeconomic variables, as many investors revised upwards their economic projections amid vaccine announcements and the subsequent rollout. As Exhibit 2 shows, smaller companies are typically more domestically focused in their revenue exposures, which helps to explain why the S&P 600’s returns have been more correlated to changes in U.S. GDP growth and consumption and investment, historically.

Some market participants might view small-caps as a relatively inefficient asset class more suited to the endeavors of active managers. However, data from our SPIVA^® Scorecards suggests otherwise: most U.S. small-cap active managers underperformed the S&P 600 in 14 of the past 20 full calendar-year periods.

Our SPIVA U.S. Mid-Year 2021 Scorecard results also made for disappointing reading for those thinking that recent market movements would have offered a more favorable environment for active managers, as 78% of U.S. small-cap active funds underperformed the S&P 600 in the 12-month period ending June 30, 2021. The equivalent figure over the three-year horizon was 54.8% and underperformance increased to 66.7%, 83.5%, and 93.8% over the 5-, 10-, and 20-year horizons, respectively.

Additionally, the S&P 600 has typically been a harder benchmark to beat than the Russell 2000, another index designed to represent the performance of small-cap U.S. equities. As we have written about before, unlike the Russell 2000, the S&P 600 employs an earnings screen and the resulting quality exposure has contributed to its outperformance, historically. More recently, differences in sector weights and constituent composition helped to explain the S&P 600’s relative returns in 2020 and its sector-led bounce back so far in 2021. In short, index construction matters!

Finally, the breadth and depth of the U.S. equity market means that the S&P 600, its returns, and its characteristics may be relevant to investors around the world. As with portion sizes, what is smaller in the U.S. is larger elsewhere. For example, Exhibit 5 demonstrates that the float market capitalization of S&P 600 constituents is equivalent to that of several countries in the S&P Global BMI. Hence, having a view on U.S. small-cap equities may be as helpful for explaining global equity returns as understanding the trends and narratives affecting those countries.