Hard to beat
The US equity market is sometimes referred to as the most efficient and over-researched market in the world. It’s an argument that some have linked to the reduced preference for active investing, judging the S&P 500 too difficult for managers to beat consistently over time. Yet a strategy exists that challenges this perception and is not only ESG compliant, low carbon, and based on research by a world-renowned economist, but also, as of September 2020, has no exposure to tech stocks. Haven’t heard of it? Let’s just call it a little-known gem.
Carmine de Franco, Head of Research at Ossiam, reveals the names and numbers behind the firm’s flagship strategy and why its ESG offshoot is proving so popular.
Why don’t you start by walking us through the name of the strategy and identify what the different components refer to?
The full name of the strategy is ‘Shiller Barclays CAPE® Sector Value Strategy’, but I’m afraid the associated fund names are even longer still. So let’s break it down, bit by bit. First, Professor Robert Shiller is a Nobel prize-winning economist from the US who has spent over 50 years studying, researching and writing about financial markets, asset prices and behavioural economics.
In the winter of 1998, together with John Campbell, Shiller published a ground-breaking article comparing stock prices with a smoothed, trailing 10-year average of real earnings rather than the traditional trailing 12-months¹. This gave rise to the term ‘Cyclically Adjusted Price-to-Earnings Ratio’ or CAPE® for short.
In 2012, Shiller collaborated with Barclays to develop a family of indices, applying the CAPE® ratio to US sectors, which has since been extended to Europe, Japan and Asia. Finally, the word ‘Value’ refers to the concept of sector rotation that underpins the index, whereby only the most undervalued of the US sectors are selected.
So how does it work in practice? What is the basis for deciding the sectors?
It all starts with determining the CAPE® ratios for the ten S&P 500 sectors. From here, we identify the five most undervalued sectors. It’s important to point out that when we say ‘undervalued’, we don’t make this judgement on a simple comparison of sector CAPE® ratios versus one another, but relative to the trailing 20-year average of the CAPE® ratio for the sector itself. Why? Because comparing the CAPE® ratio of one sector to another provides little indication as to whether one is over or undervalued.
Some sectors tend to have higher than average CAPE® ratios that persist over time, such as IT, while others tend to be lower, such as utilities. Comparing a sector’s CAPE® ratio to its own historical average creates a better indicator as to when it is over or undervalued and allows us to compare sectors.
Then, from the five most undervalued sectors, we remove the one that has the lowest trailing 12-month momentum. This helps to avoid sectors that can appear ‘cheap’ but are undergoing some form of protracted structural decline. The remaining four US sectors are then equally weighted and rebalanced on a monthly basis.
How frequently does the sector composition change?
If we take the 95-month period between the inception of the index at the end of September 2012 and the end of August 2020, there are some sectors that have been very stable in terms of their inclusion. Since 2014 up to July 2020, the Technology sector has been selected in the strategy 81 months making it the most it the most selected sector. Industrials and Healthcare have also been frequently part of the allocation –respectively 78 and 74 months. Utilities, on the other hand, has not been selected once. This year, of course, has seen a large rotation between the selected sectors: Financials entered the strategy in March while Technology went out in July. Materials, which has only been selected in 13 months, replaced Technology in July 2020.
Why did the creation of an ESG and low carbon version of the Shiller Barclays CAPE® strategy come about?
Ossiam has been developing ESG strategies since 2016. As the Shiller strategy became one of the flagships in 2017, it was important to offer investors an ESG and Low Carbon version, accredited with the French ‘ISR’ Label.
How? Well we started with a screen that removes companies in specific businesses, such as controversial weapons, tobacco and coal, and companies that experience severe controversies, as well as companies in breach of one of the UN Global Compact ten Principles. We then incorporated publicly available exclusion lists.
All these filters improve the strategy’s ESG profile. With the remaining stocks, the strategy selects the portfolio that mimics the financial behaviour of the Shiller Barclays CAPE® US Sector Value Index by minimizing the expected tracking error, while also reducing substantially the carbon footprint, which also helps to contribute positively in the fight against climate change.
Why is it an attractive investment and how might investors employ such a strategy in a portfolio?
First and foremost, the market for ESG strategies in US equities is still relatively nascent. While there have been a number of new launches in the last 12 months, there are fewer strategies with a proven longer term track record.
In addition, the dispersion between growth and value stocks has only been this stretched on two occasions since 1926, making value based sector rotation an attractive complimentary or contrarian strategy with respect to existing US equity exposure. Especially given these strategies typically have a beta close to 1.
Finally, it is actively managed which means that as ESG profiles and carbon footprints of companies within the chosen sectors evolve, whether it’s for better or worse, this will be reflected in the constituents of the strategy’s portfolio.
The content of this page has been prepared solely for informational purposes and it is not intended to be and should not be considered as an offer, or a solicitation of an offer, or an invitation or a personal recommendation to buy or sell participating shares in any Ossiam Fund, or any security or financial instrument, or to participate in any investment strategy, directly or indirectly.
Although information contained herein is from sources believed to be reliable, Ossiam makes no representation or warranty regarding the accuracy of any information of which it is not the source. The information presented on this page is based on market data at a given moment and may change from time to time.
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