Indexology^® Blog

In its Q3 2020 refunding statement¹ released on Aug. 5, 2020, the U.S. Treasury announced its plan to increase auction sizes across all nominal coupon tenors over the August-October quarter, with larger increases in longer tenors (7-year, 10-year, 20-year and 30-year).

To gauge the demand appetite for U.S. Treasuries, let’s review the size and composition of U.S. Treasury holdings by one of the larger buyers these days, the Federal Reserve. Since March 2020, the Federal Reserve has stepped in with a broad array of actions to limit the economic damage from the COVID-19 pandemic, including the resumption of security purchases. On March 23, 2020, the Fed made the purchases opened, saying it would buy securities “in the amounts need to support smooth marketing function and effective transmission of monetary policy to broader financial conditions.”

Exhibit 1 shows the significant increase of the Fed’s security holdings. Since the end of February 2020, the total amount of securities held in the Federal Reserve System Open Market Account (SOMA) increased from USD 3.8 trillion to USD 6.2 trillion, with 69% of that increase (USD 1.6 trillion) in U.S. Treasury notes and bonds. Exhibit 2 shows that as of the end of July 2020, the Federal Reserve held 28% of outstanding U.S. Treasury notes and bonds, the highest since 2003, compared with 11% in March 2009, when the Fed announced U.S. Treasury purchases in QE1.

The increase in the Fed’s share of outstanding U.S. Treasuries since March 2020 shows that the Fed’s purchases have outpaced net issuances of U.S. Treasuries. However, looking closer at the composition of the Fed’s holdings, we find that 24% of its holdings are in U.S. Treasury bonds with maturities longer than 10 years, much lower than the 59% in U.S. Treasury notes with maturities between 1 and 10 years (see Exhibit 3).

As a result, the Fed’s aggressive purchases are not immediately easing pressure on long-dated U.S. Treasury yields. Since the refunding announcement to Aug. 14, 2020, the end of the week that included three auctions of 3-year, 10-year, and 30-year U.S. Treasury bonds, 10-year U.S. Treasury yields went up by 16 bps, while 30-year U.S. Treasury yields rose by 23 bps. Weak demand for the record-sized 30-year U.S. Treasury bond auction on Aug. 13, 2020, may indicate an early sign of indigestion. In addition, net non-commercial positions in long bond futures (15-25 years) as of Aug. 11, 2020, were at a record high level since 2000, according to Commodity Futures Trading Commission data. Although record short positioning could leave the market at risk of a large short-covering rally, pressure might continue on long-dated U.S. Treasury yields.

¹  https://home.treasury.gov/news/press-releases/sm1081

In our paper “How Smart Beta Strategies Work in the Australian Market,” we examined the long-term performance characteristics of S&P DJI’s Australian factor indices in different market trends. In the first half of 2020, the Australian equities market had a roller coaster response to the coronavirus outbreak, global market crash, and government stimulus packages. While most of the factor indices behaved similarly to their long-term performance characteristics, some did not. In this blog, we divided the first six months of 2020 into three time periods based on the varying price trends of the S&P/ASX 200 and reviewed how the Australian factor indices reacted in each of these different periods with the decomposition of their returns based on factor attributions for periods.

Despite the worldwide spread of coronavirus, the Australian equities market gained 7.5% during the period from Dec. 31, 2019, to Feb. 20, 2020, largely supported by the stronger-than-expected economic data. Apart from the S&P/ASX 200 Momentum, which gained 11.3%, the rest of the S&P DJI Australian factor indices underperformed the S&P/ASX 200.

Momentum and quality factors have historically tended to outperform their benchmarks during uptrend markets. According to the factor attribution shown in Exhibit 3, style factors (especially medium-term momentum), industry biases, and stock-specific risk all positively contributed to the S&P/ASX Momentum return and resulted in strong outperformance during this period. For the S&P/ASX 200 Quality Index, despite the positive return impact contributed by style factors, industry biases (overweight in Steel and Insurance and underweight in Banks and REITs) and stock-specific risks were unfavorable for the S&P/ASX Quality Index return, and the index underperformed slightly for the period.

With increasing concerns about the coronavirus outbreak, global recession, and disruption to corporate supply chains and sales, the Australian market experienced a sharp decline starting on Feb. 20, 2020, together with the global stock market crash and oil price decline. Over the period from Feb. 20, 2020, to March 23, 2020, the S&P/ASX 200 dropped 35.9%. According to the factor index research outlined in our paper, quality and low volatility indices tended to outperform while value and small-cap indices tended to lag the benchmark during bearish markets.

During this market decline, most factor indices’ performances tended to align with their long-term characteristics. However, we noticed that the outperformance of the low volatility index was not as pronounced as what we saw in previous market sell-offs. According to the factor attribution, both the style factor exposures and stock-specific risk positively affected the return of the S&P/ASX 200 Low Volatility Index. However, the strong industry bias to REITs (one of the worst-performing industries during this period) severely dragged the index return and eroded the outperformance of the index.

Following a series of health and safety measures (closing borders, imposing social distance rules), interest rate cuts, and government stimulus and subsidy packages, the S&P/ASX 200 started to rebound after touching its lowest point on March 23, 2020. The S&P/ASX 200 posted a gain of 30.1% during the market rally from March 23, 2020, to June 30, 2020. Historically, momentum, quality, and small-cap indices tended to outperform their benchmarks, while value, dividend, and low volatility tended to underperform during bullish markets. However, in this recent rally, the S&P/ASX Quality Index underperformed the S&P/ASX 200 by 3.8% while the S&P/ASX Dividend Opportunities Index outperformed by 2.3%.

For the S&P/ASX 200 Quality Index, the targeted exposures to profitability and leverage, as well as the industry biases, contributed positively to the index return. The unintended exposure to short-term momentum negatively affected the index, resulting in underperformance. For the S&P/ASX Dividend Opportunities Index, the dividend yield and value factors generated negative returns in this period, though the industry biases (underweight in Consumer Staples and REITs; overweight in Metals & Mining [ex-Gold & Steel], Utilities, and Consumer Discretionary) and stock-specific risk contributed positively to the dividend index performance and led to index outperformance.

Overall, the S&P/ASX 200 Momentum and S&P/ASX 200 Quality Index were the best-performing Australian factor indices in the first half of 2020, while the S&P/ASX 200 Enhanced Value performed the worst. Most factor indices aligned with their long-term cyclical characteristics, with a small number of them showing different behavior largely due to industry biases and unintended factor exposures.

The previous blog highlighted the significant shifts to passive investing in India. However, Indian passive trends have continued to favor plain vanilla indices due to their ease of understanding, rather than exploring alternative thematic indices, such as the S&P Kensho New Economies Indices or factor Indices. However, once the acceptability and acceptance of passive investment grows, the need for variety will arise. The simple progression would be toward factor play initially.

The month-end statistics for May 2020 revealed the parity of global and Indian markets in the quality factor. Companies with low leverage and high returns on equity have rewarded the quality factor. The S&P BSE Quality Index gained 2% in May 2020 and outperformed the S&P BSE SENSEX by 11%. The U.S., European, and Australian markets witnessed the same monthly trends (see Exhibit 1).

Taking a long-term perspective on any investment strategy is essential, including passive strategies. Exhibit 2 shows that market cycles over different time periods reflected different performance results for the quality factor, however, it was the long-term winner.

There is a need for more education and investor awareness on the benefits of passive investing. It is important that investors understand that passive investing involves an investment strategy that tracks or mimics an index. The advantages of diversification, low concentration risk, transparency, and lower costs strengthen the case for choosing this option. Index-based investing makes it easy for those who are not actively tracking markets by allowing them index-based returns.

Historically, Indian markets have been a pure active investing play in which funds were deployed by active fund managers in various strategies. With the dawn of passive investing, the value of low-cost indices with no active bias, consistent methodologies, and transparent rules started gaining attention. The SPIVA® (S&P Dow Jones Indices versus Active) India Scorecard added some more conviction to the passive claims. The SPIVA India Scorecard, which was first published in 2013, has laid witness to the fact that benchmarks have outperformed active funds. One such example has been the large-cap space that has witnessed a consistent 50% and above outperformance of benchmarks over active funds in the 5-year and 10-year investment horizons.[1]

The Indian passive wave has received the necessary nudge by initiatives from the Indian government, be it the Employees Provident Fund allocations to exchange-traded fund (ETFs) in benchmark indices, the disinvestment program being mobilized via the ETF route, or encouraging retail participation in fixed income via passive strategies. These initiatives have provided the necessary impetus to the passive market in India to gather more participation from product issuers and investors. While it is still early days for a wider selection and more innovative products, this is a great beginning to an optimistic growth trajectory for the Indian passive market.

[1] SPIVA India Year-End 2019 Scorecard.

On April 13, 2020, the Dow Jones REIT Index Series welcomed a new index—the Dow Jones Equity All REIT Capped Index. The strategy is a subindex of the Dow Jones Equity All REIT Index, which was launched in January 1997. Although both indices were designed to measure the performance of all publicly traded REITs, the newly launched Dow Jones Equity All REIT Capped Index has some unique features.

The Dow Jones Equity All REIT Capped Index seeks to represent the largest and most liquid REITs. To be eligible for inclusion in the index, a REIT company must have a minimum float market capitalization (FMC) of USD 200 million. An existing constituent becomes ineligible if its FMC falls below USD 100 million for two consecutive quarters. In addition, all index constituents must have a median daily value traded (MDVT) of at least USD 5 million over the prior three months. The MDVT for any existing constituents is USD 2.5 million.

The additional market cap and liquidity criteria can potentially improve the tradability of the index. Exhibit 1 and 2 compare the FMC and MDVT[1] between the Dow Jones Equity All REIT Index and the Dow Jones Equity All REIT Capped Index. Over the past five years, the size and liquidity of the Dow Jones Equity All REIT Capped Index were higher by about 30% over its benchmark index.

The multiple capping rules historically helped the Dow Jones Equity All REIT Capped Index reduce concentration and improve diversification. At each rebalancing, the weight of an index member is capped at 10%, and all constituents that have a weight greater than 4.5% in aggregate are limited at 22.5% of the index. Exhibit 3 shows the weight comparison as of May 29, 2020. The total weight of all constituents with a weight above 4.5% in the Dow Jones Equity All REIT Capped Index is 8.29% less than that of the uncapped version.

With improved tradability and diversification, the index has had a comparable performance with the Dow Jones Equity All REIT Index. Exhibit 4 illustrates that the performance of the Dow Jones Equity All REIT Capped Index is not compromised by the additional rules for size, liquidity, and diversification. While the index outperformed over the short term (one- and three-year periods), both indices had similar absolute and risk-adjusted returns over the long term (since the Dow Jones Equity All REIT Capped Index’s inception date of March 19, 2010).

[1] The FMC and MDTV data is calculated as follows: At each quarterly rebalancing, the median values of the FMC and MDTV are calculated. The average of the median values for each year are used for comparison.

The year 2020 has brought about many unexpected turns of events. The COVID-19 pandemic, which will be marked in history as one of the most-acute pandemics that the world has had to experience, is one.

Another area that has seen a transformation in the financial investing space is the realization and acceptance of passive investing. The recent growth trends globally and in India are marking new trajectories. The global growth story in passive products has been strong and broadening, with new innovations and themes. India has played catch-up, with the exponential growth in assets in the past few years revealing the potential for the passive space in the region.

As of March 2020, global assets in passive products passed USD 5 trillion, with over 7,000 passive products. The U.S., with a market share of 68%, USD 3.6 trillion in assets, and over 2,000 products, is followed by Europe and Japan with 16% and 6.5% of market share, respectively. The global asset mix is skewed toward equities, leading with a 70% share in assets at USD 3 trillion, followed by fixed income with a 21% share at USD 1 trillion.

For India, though the numbers are far more modest, the growth has been encouraging, with the total assets under management in passive products at USD 24 billion and 86 passive products. Five years ago, the scenario in India included a mere USD 2 billion in assets and 57 products. A decade back had far less, with USD 1 billion and 26 products in the market. Hence, the progress made by the country has been remarkable, especially in the backdrop of a faster-paced active investing market. Two years ago, the exchange-traded fund market constituted 2.2% of the mutual fund industry, while in December 2019, it stood at 7.5%.[1]

Global themes in passive products have progressed from plain vanilla asset classes, geographies, segments, and market benchmarks to factors that could be single or multi-factor, thematic-like infrastructure or corporate clusters, sustainability (a popular and fast-growing segment), and so on. Furthermore, advanced concepts are being explored via indices, such as new economies. For example, the S&P Kensho New Economies Indices are a family of indices tracking the industries and innovations of the Fourth Industrial Revolution.

Rapid developments in artificial intelligence and robotics, coupled with exponential processing power and ubiquitous connectivity, are driving structural changes in the global economy, disrupting existing industries and forging new ones. The S&P Kensho New Economies Composite Index is designed to measure the performance of companies involved in the New Economies 21st Century Sectors, including a dynamically adjusted list of companies drawn from all of the S&P Kensho New Economy subsector indices. The S&P Kensho New Economies Select Index measures a subset of the five best-performing subsector indices.

These new innovative indices are breaking grounds in investment themes and products that offer further variety to portfolio strategies.

[1] Source: https://etfgi.com. March 2020.