2015 taking the best path to indexing

Figure 1: The Sharpe ArgumentIf active and “index” management styles are defined in ‘sensible’ ways:

1. Before costs, the return on the average actively managed dollar will equal the return on the average index-managed dollar and;

2. After costs, the return on the average actively managed dollar will be less than the return on the average index-managed dollar

Sharpe argued that these assertions hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.

Source: W Sharpe, Arithmetic of Active Management, 1991.

IQ INSIGHTSTaking the Best Path to Indexing

William Sharpe set out the Capital Asset Pricing Model (CAPM) in his 1970 book, “Portfolio Theory and Capital Markets”. The CAPM theory states that the market portfolio, which includes all assets in proportion to their value, is efficient and that asset returns are proportional to their market risk. Yet the theory has not been borne out over the past 20 years, using the MSCI World Index as a proxy for the market portfolio.

Sharpe also promoted the idea of the average portfolio. He defined the average portfolio as the market-cap portfolio and stated that it should outperform the average active portfolio because of its lower turnover and lower costs. This assertion has been empirically verified. Is it, then, more accurate to highlight the benefits of indexing in terms of low turnover rather than low tracking error? And is the best indexing strategy simply buy and hold?

The Sharpe Argument: the Case for the Average Portfolio First, it’s useful to review the core arguments as expressed by Sharpe in his 1991 publication, “Arithmetic of Active Management”.

Notably, there is no reference to the efficient portfolio in Sharpe’s argument for the average portfolio, but simply the concept of outperforming the majority of portfolio managers. A portfolio is deemed ‘good’ if it outperforms 50% of its peers whatever its performance and risk levels. The average portfolio will outperform 50% of its peers because it is the average managed dollar portfolio, i.e., the market-capitalisation portfolio within its universe.

In addition, Sharpe’s argument is valid for any universe of average active and index-managed dollar portfolios, be it countries, developed markets, emerging markets, small–capitalisation, equities and so on. The larger the universe, the stronger the argument for investing in the average portfolio because of the higher level of competition.

Sharpe concludes that the average index–managed dollar portfolio outperforms because of its lower transaction costs and lower turnover.

by Frédéric Jamet Head of Investments, SSGA France

State Street Global Advisors 2

IQ Insights | Taking the Best Path to Indexing

Figure 3: The Turnover of the Market-Cap Index Compared with Actively Managed Investing

S&P 500 S&P 500 Equal Weighted

Year Turnover (%) Turnover (%)

2005 5.7 20.0

2006 4.5 21.6

2007 5.2 28.4

2008 3.9 38.5

2009 4.5 33.3

2010 3.7 20.4

2011 3.6 21.9

2012 4.4 21.1

2013 3.3 17.8

2014 3.1 18.1

Five-Year Average 3.6 19.9

MSCI World MSCI World Equal Weighted

Year Turnover (%) Turnover (%)

2005 4.1 24.5

2006 3.9 24.7

2007 6.2 27.7

2008 3.3 41.9

2009 2.6 34.8

2010 2.6 23.5

2011 2.2 23.7

2012 2.6 25.4

2013 3.9 22.3

2014 4.0 22.6

Five-Year Average 3.0 23.5

Source: SSGA, MSCI, one-way turnover, as of 31 December 2014.

Figure 2: The Outperformance of the Market-Cap IndexPercentage of Equity Funds Outperformed by their Benchmark

Fund Category Benchmark Index One Year (%) Three Years (%) Five Years (%) Ten Years (%)

Global Funds S&P Global 1200 76.89 73.84 75.46 79.17

International Funds S&P 700 68.9 58.5 62.54 84.09

International Small Cap Funds S&P Developed ex US Small Cap 69.44 50.82 51.92 58.14

Emerging Markets Funds S&P IFCI Composite 68.7 65.97 72.19 89.71

Source: S&P Dow Jones, CRSP , 2014, as of 31 December 2014.

Past performance is not a guarantee of future results.

Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.

The calculation method for value added returns may show rounding differences.

The points noted above would suggest that portfolios with a larger market capitalization, greater global coverage, and lower turnover stand to outperform. But are global market-capitalisation portfolios low turnover portfolios in reality and do they really outperform active portfolios?

Performance and Turnover of the Market-Cap Index In the main segments of the markets, as Sharpe theorised, the market-cap index has significantly outperformed the average actively managed portfolio over both the short and long term, as illustrated in Figure 2.

As shown above in Figure 2, the percentage of funds outperformed by the market-cap index has increased over time, supporting the idea of a cumulative burden arising from regular transaction fees and turnover.

In terms of turnover, the lower the turnover of the market-cap index, the larger the index’s outperformance should be compared with the average active portfolio manager. The proxy for active portfolio manager turnover used in Figure 3 is the equal-weighted index; this is a somewhat prudent approach as turnover for active portfolios can easily go beyond 100%. As shown, the turnover of the market-cap index, in this case the S&P 500 Index and the MSCI World Index, is significantly lower than that of the equal–weighted index.

While the turnover of these market-cap indexes is low, it is not insignificant. How would a portfolio following a pure buy-and-hold methodology perform in comparison?

Performance of the Minimum Turnover PortfolioLet’s consider the turnover of a global market-capitalisation index.

Theoretically, the composition of a market-cap index with no stocks added or deleted and no corporate action will remain unchanged. A market-cap portfolio that replicates the market-cap index and has no dividends and subscriptions/redemptions will remain perfectly aligned with the market-cap index, and will be unaffected by market volatility.

In reality, however, the market-cap index is modified by additions/deletions of stocks and by corporate actions, and a market-cap portfolio is affected by dividends and subscriptions/redemptions. So a market-cap index will have a turnover greater than zero and the market-cap portfolio’s turnover will be the same as or higher than that of the market index.

A buy-and-hold portfolio, which simply reinvests dividends into the market-cap index without selling any stocks could theoretically reach a turnover of zero. A pure buy-and-hold portfolio, which reinvests dividends into itself, without selling any stock and without buying any new stock added to the market-cap index, could also reach zero turnover.



However, in reality, the performance of a buy-and-hold or pure buy-and-hold portfolio would drift away from the market-cap index as a result of dividend distributions and the addition to/deletion from the market-cap index of new stocks.

In 2006, Siegel and Schwartz studied the performance of the pure buy-and-hold S&P500 portfolio. Their findings are summarised in Figure 4.

The pure buy-and-hold portfolio, where the proceeds of dividends, mergers and splits have been constantly reinvested, recorded a return of 11.4% over the period, compared to 10.9% for the S&P 500 Index, and achieved a lower volatility than the index.

We backtested the performance of a buy-and-hold and pure buy-and-hold portfolio for the constituents of the MSCI World Index over the 10-year period from 2004 to 2014. The pure buy-and-hold portfolio reinvests only into the same initial assets or their descendants as the MSCI World Index in 2004. The buy-and-hold portfolio reinvests only into the initial assets during 2004, and after one year readjusts to the official MSCI World Index constituents at the start of 2005. The portfolio then reinvests only into this new MSCI World for one year, until the next annualised readjustment.

The performance of the two portfolios is illustrated in Figure 5.

The pure buy-and-hold portfolio experienced moderate swings in terms of out- and underperformance vis-à-vis the MSCI World Index, with a tracking error of 2.7%. By comparison, the buy-and-hold portfolio has a low tracking error of 0.3%. The performance of the two portfolios is very close to that of the MSCI World Index, but their volatility is lower. This could be attributable to the bankruptcy of some risky stocks that were not replaced or at least were not replaced immediately in the pure buy-and-hold and buy-and-hold portfolios.

Figure 6 shows the returns of the top and bottom 10 holdings in the pure buy-and-hold portfolio, highlighting the increasing concentration of the pure buy-and-hold portfolio resulting from the bankruptcy of risky stocks (highlighted in Figure 6 below).

The top 10 stocks in the pure buy-and-hold portfolio become overweight versus the MSCI World Index; Exxon Mobil, for example, has a weighting of 2.4% in the pure buy-and-hold portfolio compared with 1.2% in the MSCI World Index.

The concentration that arises because deleted stocks are not replaced is the main problem in pure buy-and-hold portfolios. However, the buy-and-hold portfolio appears to offer an interesting trade-off, with lower turnover, better returns and lower volatility than the market-cap index.

Figure 4: Pure Buy and Hold S&P 500 Portfolio Performance, 1957-2003

Pure Buy Hold (%) S&P 500 (%)

Return 11.4 10.9

Volatility 16.1 17.0

Return/Volatility 70.9 63.7

Source: Siegel and Schwartz, 2006, “Long-Term Returns on the Original S&P 500 Companies”, Total Descendants Portfolio Value Weighted from 1957 to 2003, in US dollars. Past performance is not a guarantee of future results. Characteristics are as of the date indicated, are subject to change, and should not be relied upon as current thereafter. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.

Figure 5: Backtested Pure Buy-and-hold and Buy-and-hold Portfolio Performances Versus the MSCI World Index

Pure Buy & Hold (%) Buy & Hold (%) MSCI World (%)

Return 6.0 6.1 6.0

Volatility 17.7 19.8 20.1

Return/Volatility 33.8 30.8 30.1

Tracking error vs MSCI World 2.7 0.3 —

Source: State Street Global Advisors. Data is from 1 January 2005 to 31 December 2014. Past performance is not a guarantee of future results. Characteristics are as of the date indicated, are subject to change, and should not be relied upon as current thereafter. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. The data displayed is a hypothetical example of back-tested performance for illustrative purposes only and is not indicative of the past or future performance of any SSGA product. Back-tested performance does not represent the results of actual trading but is achieved by means of the retroactive application of a model designed with the benefit of hindsight. Actual performance results could differ substantially, and there is the potential for loss as well as profit. The performance may not take into account material economic and market factors that would impact the adviser’s actual decision-making. The performance does not reflect management fees, transaction costs, and other fees expenses a client would have to pay, which would reduce returns. Please reference the appendix for the model methodology and other important disclosures. SSGA does not yet manage actual assets to this strategy. A complete list of the firm’s composites and their descriptions is available upon request.

(%)

4

2

0

-2

-4

-6

6

— Pure Buy Hold — Buy Hold

2005 2008 2011 2014

Source: Factset based on estimates, actual portfolio level returns may vary.



Figure 6: Top 10 and Bottom 10 Stocks in the Buy and Hold Portfolio

Name Total Return (%)Pure Buy Hold

Begin Weight (%)Pure Buy Hold

End Weight (%)MSCI World

End Weight (%) Contribution (%)

Exxon Mobil Corporation 111.7 1.6 2.4 1.2 1.8

Apple Inc. 2393.0 0.1 2.3 2.0 2.9

Microsoft Corporation 101.9 1.3 1.8 1.1 1.3

Johnson & Johnson 102.4 0.9 1.2 0.9 0.9

Nestle S.A. 239.7 0.5 1.2 0.7 1.2

International Business Machines Corporation 83.3 0.8 1.1 0.5 0.7

General Electric Company -11.5 1.9 1.0 0.8 -0.2

Chevron Corporation 168.8 0.6 0.9 0.6 0.9

Pfizer Inc. 55.3 1.0 0.9 0.6 0.6

Intel Corporation 89.2 0.7 0.9 0.5 0.7

Nortel Networks Corporation -99.7 0.1 0.0 0.0 -0.1

Countrywide Financial Corp. -87.6 0.1 0.0 0.0 -0.1

Motors Liquidation Co -97.9 0.1 0.0 0.0 -0.1

Lehman Brothers Holdings Inc. -99.6 0.1 0.0 0.0 -0.1

National City Corp. -94.6 0.1 0.0 0.0 -0.1

Washington Mutual, Inc. -99.9 0.2 0.0 0.0 -0.2

Merrill Lynch & Co. Inc. -79.2 0.3 0.0 0.0 -0.2

HBOS Plc -92.3 0.3 0.0 0.0 -0.3

Dell Inc. -66.3 0.5 0.0 0.0 -0.3

Wachovia Corp. -88.1 0.4 0.0 0.0 -0.4

Source: SSGA, MSCI, Factset, 2004–2014, in US dollar.

Bankrupt Stocks

Past performance is not a guarantee of future results.

Weights are as of the date indicated, are subject to change, and should not be relied upon as current thereafter.

This information should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security.

The Benefits of Buy-and-Hold Index InvestingThe market-cap portfolio is not necessary efficient, but it does provide a proxy for the average performance of all portfolios.

In addition, it is a low-turnover portfolio that, according to Sharpe, should outperform at least 50% of the competition.

A buy-and-hold portfolio constructed initially as a market-cap portfolio, but maintained as a minimum turnover portfolio,

may achieve moderate tracking error and risk-adjusted performance that is slightly above the market-cap index.

Crucially, the main drivers of this result are the portfolio’s market-cap weighting, global coverage and low turnover. The low tracking error should be viewed as a consequence more than a pre-requisite of an index portfolio.


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The views expressed in this material are the views of Frederic Jamet through the period ended October 31, 2015 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

Backtested Performance Methodology

1.The back tested performance is a pure buy and hold strategy, computed through Factset 2.The universe and securities used are the MSCI World 3. It is assuming benchmark holdings at the beginning of each period, and buy and hold total return through the period. New securities added to the MSCI World through the period are not taken into account. 4.The performance is computed gross of fee, without any transaction costs nor administrative fee. All dividends are reinvested. 5.The back tested performance is not necessarily indicative of future performance

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The information provided does not constitute investment advice as such term is defined under the Markets in Financial Instruments Directive (2004/39/EC) and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any investment. It does not take into account any investor’s or potential investor’s particular investment objectives, strategies, tax status, risk appetite or investment horizon. If you require investment advice you should consult your tax and financial or other professional advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.

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Risks associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions.

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