On June 19, 2018 I attended the S&P Dow Jones Indices Denver Financial Advisor Forum in support of our Reverse Cap Index, which is an S&P Dow Jones calculated index that is comprised of the same underlying constituents as the S&P 500, but weighted by (1/Market Cap) – resulting in a reverse ordering of those stocks. This strategy by nature, systematizes a “Buy Low, Sell High” rebalance structure, which has historically provided additional return (albeit alongside addition volatility) above the traditional Cap Weighted S&P 500 and Equal Weight S&P 500 Indices. Here are my five most interesting takeaways from the event.
1. Midterm Elections Matter to Financial Markets – Sam Stovall, the Chief Investment Strategist at CFRA gave a presentation on his 2018 Market Outlook and highlighted the fact that years which host midterm elections, have historically had increased volatility and have ended the year in negative territory 50% of the time (60% of the time in 1stterm presidencies). Given the market’s proclivity for rising over time, that 50% figure is indeed meaningful. This phenomenon makes sense, as the uncertainty around the near-term complexion of congress has direct implications on economic policies moving forward. Stovall further presented, that in every occurrence in which the market posted a negative return in a midterm election year, the market then finished higher in the 12-month period following the election results. This seems to be another expression of the well understood notion that the market does not like uncertainty and something to keep in mind for the duration of 2018.
2. Passive Funds are Putting Poor Active Managers Out of Business – This observation was presented by Craig Lazzara, the Managing Director of Index Investment Strategy at S&P Dow Jones Indices. He discusses the idea within the framework (and citing SPIVA) that passive vehicles provide low cost broad exposure that is difficult for active managers to beat. Therefore, the worst of the active managers are being put out of business. This idea makes a lot of sense given the low-cost alternatives that vehicles like ETFs provide and is a net positive for investors in my opinion. However, he then suggested that that the exit of these less skilled alpha managers, actually reduces the pool of available alpha for the remaining active managers. Lazzara cited the idea that alpha is zero-sum (I.e. One manager’s alpha must coincide with another managers negative alpha) and that an increasing amount of “Passive” investment vehicles reduces the available alpha, which also becomes increasingly competitive among the remaining (more skilled) active managers. This is an interesting notion that I am not sure I agree with, because it seems to assume that passive vehicles cannot be alpha generating. This may come down to the definition of “Passive”, as even the S&P 500 is not just a list of the 500 largest companies, there is a selection committee which in and of itself qualifies as a certain amount of active management. Smart Beta ETFs, although index based, can still be a source of positive/negative alpha for active managers to compete against.
3. Less Dispersion and Higher Correlation in Stocks Limit Alpha Opportunities –Post 2008 financial crisis, the dispersion of stock returns narrowed to near all time low levels. As correlations rise, the opportunity to select stocks that significantly outperform the index decreases. When the majority of stocks act very similar to the Index benchmark, by definition it becomes more difficult to beat that benchmark. This phenomenon served to expedited flows from away from Active managers to Index based products, something that benefits investors – as the evolution of Indexing has given the masses low cost access to a broad array of innovative investment products.
4. Defining a Factor– One interesting panel held at the conference was on current opportunities in multi-factor strategies. “Factor” funds have long been a staple of the smart beta suite of ETFs. However, there does exist a debate about how many true factors exist. I highly recommend this article published by the University of Chicago Booth School of Business in which they analyze 300 reported factors and find only 13 of them to be significant. In the authors opinion, a large portion of those newly introduced factors are actually just different ways of expressing existing factors. One simple, yet elegant definition of a factor – came from Matthew Papazian, Founding Partner of Cardan Capital Partners, a Denver area advisor. He defined a factor as something intrinsic to the market that is broad and simple. Importantly, it cannot involve an information edge, because then it would become a trading strategy that can be competed away over time if adopted by many market participants.
5. IMO 2020 – The final presentation of the afternoon was by Thomas Watters, the Managing Director for the Energy Sector of S&P Global Ratings. He discussed a pending international rule that all maritime shippers need to cut the sulphur emissions in their fuel by 2020. As Thomas explained, this will greatly increase the demand for light crude, such as that produced by the Permian Basin in the US – while decreasing demand for the heavier crude produced in the Middle East. However, lagging infrastructure investment and regulatory challenges have exacerbated the pipeline capacity problem currently experienced by North American producers, which is not expected to be relieved until more capacity comes online near the end of 2020. For those who understand the energy space, this could provide an interesting opportunity.
Posted by: Josh Blechman 06.22.2018