Indexology^® Blog

The U.S. Energy Information Administration (EIA) forecasts that power generation coming from renewable sources, such as wind, solar, hydro, and geothermal, should provide the majority of the world’s energy needs by 2050.¹ The use of renewable energy has been increasing significantly over the last decade, however its current level of consumption still lags those of traditional sources of energy.

The primary driver behind the shift from traditional energy sources, such as petroleum, natural gas, and coal, to renewables comes from a “critical mass” of governments around the world looking to adopt policies that seek to lower the global carbon footprint.

Most notably, the landmark Paris Agreement—which calls to keep the increase in global average temperature to well below 2°C above pre-industrial levels and aims for a climate-neutral world by mid-century—was signed by nearly 200 countries and went into effect in 2016.² There have been hiccups along the way, including the world’s largest economy and one of the largest carbon emitters, the U.S., withdrawing. However, the election of President Joe Biden in the 2020 U.S. election brought renewed hope given his campaign promises. Indeed, in the first few hours of taking office, the new president signed an executive order to have the U.S. rejoin the agreement in full.³

The renewable energy industry has grown over the last decade, rising from approximately 10% of all energy produced in 2010 to 22% as of November 2020 in the U.S.⁴ Despite this growth, significant additional changes are needed well before the mid-century mark to hit the stated climate goals. The need for increased renewable production and efficiency is perhaps evident, but more investment into equipment is needed as well to further support increased production and efficiency. In fact, the International Renewable Energy Agency (IRENA) has stated that annual investment in the renewables space must increase by almost triple to USD 800 billion between 2020 and 2050.⁵

Come 2050, electricity generation from renewables is expected to come from a well-diversified mix led by solar, wind, and hydro. Based on these projections, focusing on just one area of renewable energy would leave out significant exposure to the overall industry.

In addition, the clean energy push clearly needs to be a global phenomenon, as the growth in consumption through 2050 will primarily be from non-OECD countries.⁶ Therefore, having a global perspective when it comes to meeting the expected growth is useful.

With the surge in demand for renewable energy, companies in the clean energy space are poised for similar growth. How does one capture the theme and track the performance of clean energy companies? Launched in 2007,⁷ S&P DJI offers the S&P Global Clean Energy Index, which provides liquid and tradable exposure to 30 leading clean energy companies. The index attempts to represent the full clean energy ecosystem by including companies both on the production and the technology & equipment sides in the various segments of renewable energy across the globe.

¹ https://www.eia.gov/todayinenergy/detail.php?id=42555#

² https://unfccc.int/process-and-meetings/the-paris-agreement/the-paris-agreement

³ https://www.whitehouse.gov/briefing-room/statements-releases/2021/01/20/paris-climate-agreement/

⁴ https://www.eia.gov/electricity/monthly/current_month/january2021.pdf

⁵ IRENA and CPI (2020), Global Landscape of Renewable Energy Finance, 2020, International Renewable Energy Agency, Abu Dhabi.

⁶ Organisation of Economic Co-operation and Development (OECD).

⁷ The index was launched on Feb. 22, 2007 with a base date of Nov. 21, 2003.

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We recently issued our mid-year SPIVA^®  reports for the U.S., Australia, and Europe, and other regions will follow in due course.  Although one can sometimes find exceptions in the short run, the long-term results of SPIVA can be easily summarized:

• The majority of active managers underperform most of the time.
• Historical success does not predict future success.

SPIVA continues a line of inquiry that began nearly 90 years ago with the first study of active fund performance versus passive benchmarks.  This work accelerated in the 1970s, as the growth of professional portfolio management drew increasing academic interest.  Nobel laureate Paul Samuelson was representative of his contemporaries in suggesting that “most portfolio decision makers should go out of business.”

Active managers didn’t take kindly to Samuelson’s suggestion in 1974 and, despite the accumulation of confirming evidence since then, they don’t take kindly to it today either.  We’ve estimated that the cumulative cost savings to asset owners just from indexing the S&P 500, S&P MidCap 400, and S&P SmallCap 600 amount to better than $300 billion, and every dollar of costs saved by the investor is a dollar of fees not paid to an active manager.  So while resentment is to be expected, it’s surprising that critics of SPIVA sometimes focus on its minutiae, rather than on its results.

The most important thing to realize about SPIVA results is that they are not a coincidence.  The active management community didn’t lose a cosmic coin flip 90 years ago; active underperformance happens for a set of readily identifiable reasons.  These include:

Professionalization.  Portfolio management is a zero-sum game; the only source of alpha for the winners is the negative alpha of the losers.  When most of the assets in a market are professionally managed, the average professional won’t beat the market because the average professional is the market.  It’s not a coincidence that the first index funds were launched in the 1970s; by that point the U.S. equity market had been largely professionalized.

Cost.  The expense ratio of the average actively-managed equity mutual fund was 0.74% in 2019; the average index fund cost 0.07%.  The average active manager therefore starts out 67 basis points in the hole.

Skewness.  The distribution of stock returns is skewed – i.e., most stocks underperform the market average.  Exhibit 1 illustrates this for the S&P 500.

Exhibit 1.  Most Stocks Underperform the Market Average

Source: S&P Dow Jones Indices LLC, FactSet. Data from Dec. 31, 1998 through Dec. 31, 2019.  Past performance is no guarantee of future results.  Chart is provided for illustrative purposes.

Of the 1010 stocks that were part of the S&P 500 between 2000 and 2019, only 267 returned more than average.  The probability that a randomly-chosen stock would deliver above-average performance, in other words, was 26%, not 50%.  When fewer stocks outperform, active management is harder.

These (and other!) reasons are robust and sustainable.  Investment management will stay professionalized, active costs will always exceed index costs, and in most years most stocks underperform the average in most markets.  The index advantage is likely to persist.