Passive Perspectives: Fourth Quarter 2022
In this article:
- Market volatility rewarded diversified indices in 2022
- The case for Stratified Weight in 2023
- Leading Themes: Infrastructure, Defensives and Inflation
- Laggard Theme: “Advertising Revenue Model”
The Stratified LargeCap Index outperformed by 9.3% in 2022
Equities rebounded strongly in Q4 as markets began to discount long-term interest rates lower than had been previously expected. Consumer stocks staged a recovery, as did a wide range of growth companies. Despite the rising markets, Q4 highlighted the danger of taking concentrated stock positions, especially in mega-cap companies, as Tesla halved in value and Amazon fell by over 25%. These two positions alone caused a significant 2% drag on the cap-weighted S&P 500 Index, which rose 7.6% compared to the S&P 500 Equal Weight Index, which gained 11.6%.
The power of business risk diversification in 2022 was demonstrated by the Stratified US LargeCap Index, which substantially outperformed the S&P 500 by 9.3% and, due to its lower allocation to underperforming Information stocks, outperformed the S&P 500 Equal Weight Index by 2.7% (Exhibit 1).
Exhibit 1. Core Index Comparison
*Syntax Stratified Europe & Asia Developed Markets (SEADM) Index is based on the MSCI EAFE universe.
International indices fared better than their US counterparts, due in part to their dramatically different sector compositions. The MSCI EAFE Index has significantly higher value exposure than the S&P 500, given its large number of Financials and Industrial companies relative to Technology stocks. By diversifying business risk, the Syntax Europe, Asia Developed Market (SEADM) Index allocated a larger weight to Information and IT stocks than the cap-weighted MSCI EAFE Index, resulting in MSCI EAFE’s marginal outperformance of +1.9% in 2022.
This trend was also observed among the smaller cap indices. The Stratified SmallCap Index underperformed the S&P 600 Index by 2.1% in 2022, driven by its 4% overweight (13.8% vs 9.8%) in underperforming tech stocks.
The Case for Stratified Weight in 2023
For most investors, 2022 was a challenging year. Every major benchmark across almost every asset class suffered significant declines. To put it in historical context, over the last 50 years, 2022 was the only year where both global stocks and bonds declined: the MSCI World Index fell 18.1%, and theBloomberg Aggregate Bond Index had its worst year ever, falling 16.3%. The main driver of these declines was the significant (inflation-fueled) rise in global interest rates. The Federal Reserve hiked rates from 0.25% to 4.5% in the US, while the UK and European central banks hiked their reference rates from near zero to 3.5% and 2.5%, respectively.
As we have consistently highlighted in our research, market cap-weighted indices often become overexposed to groups of companies with common business risks, such as the current concentration in technology stocks within the US large-cap space. The rising interest rate environment in 2022 created a significant headwind for the S&P 500, whereas the Stratified LargeCapIndex fared considerably better.
We expect this relative outperformance to persist for these key reasons:
- Prolonged macroeconomic uncertainty amidst tight monetary policy
- Cap-weighted market indices remain concentrated
- The long-term, consistent outperformance of our Stratified Weight indices, particularly if value stocks continue to outperform.
- As we begin 2023, many of the same macro-level risks that framed 2022remain: heightened geopolitical tensions with China and Russia coupled with lingering global inflation, energy and food shortages and above all else,tightening monetary policy. In other words, we expect more of the same macroeconomic uncertainty that was experienced in 2022.
During periods of uncertainty and volatility, it has historically been prudent to have diversified portfolios. The same market risks, for the S&P 500, that were in place at the start of 2022 remain today, albeit to a lesser extent. These risks include an over reliance on a handful of mega-cap companies to drive performance and a large concentration in high multiple technology stocks.
The largest companies in the Index often face specific challenges due to their size. The complexity of the largest companies makes high growth rates harder to achieve and hampers their ability to adapt to change than smaller, more nimble companies. Mega-cap companies also tend to face increased regulatory scrutiny, as is the case with the largest stocks today. These headwinds may explain why the largest cap-weighted companies in the Index do not remain the largest holdings indefinitely (Exhibit 2).
Since peaking as a top index holding, the individual weights of the ten largest stocks in the S&P 500 at the beginning of the last four decades have declined meaningfully.
Exhibit 2. Challenge to Stay on Top - Declining Weight of the S&P 500’s Largest Holdings (1990-2020)
The overdependence on a small number of stocks is only part of theconcentration problem of cap-weighted indices. Technology companiesremain overrepresented in the S&P 500 Index. At the start of 2022, technologycompanies made up 42.3% of the S&P 500. Our Affinity® data shows thatstocks exposed to the technology theme fell 25.1% in 2022 (Exhibit 7),explaining why the weight of technology names in the Index has similarlyfallen to 33.4%.Exhibit 3 below shows the proportion of technology companies in the Indexthat has declined is currently at the same level as in March 2000 during thepeak of the DotCom bubble. However, one interesting observation is that thiscycle’s technology concentration is driven by Software, rather than Hardware(as was the case in March 2000) companies.
Exhibit 3: Current technology concentration is at similar levels to that of theDotCom Bubble
Over the past two years, Value has outperformed Growth and with it, theStratified LargeCap Index has outperformed the S&P 500. Exhibit 4 showshow the relative performance of Value vs. Growth has had a strong bearingon the relative performance of Stratified vs. Cap-weighted indices in the US.Since 2021, the correlation between the relative performance of Value vs.Growth and the Stratified LargeCap vs. the S&P 500 was 0.84.
Exhibit 4: Value vs. Growth has been Correlated with Stratified vs. Cap-Weight
As shown in Exhibit 5, before 2021, Value had persistently underperformedGrowth since 2008, and the relative performance of Value over the past two years has plenty of scope to continue.The lesson from the 2000 episode is that even though growth stocks had under performed significantly by the end of 2000, their persistently high valuations and their oversized weight within cap-weighted indices created ample room for them to fall further, as investors changed their investment style to focus more on valuations.
The business risk concentrations that Stratified Weight indices seek to diversify can cause a meaningful drag on core index performance.We believe that this is why Stratified Weight indices, such as the StratifiedLargeCap Index, have outperformed cap-weight indices over the long run.Exhibit 6 illustrates the consistent outperformance of the Stratified LargeCapIndex versus the S&P 500 and the S&P 500 Equal Weight, over several key time frames.
Stocks aligned with Inflation, Infrastructure and Defensive investing outperformed last year
Using the Syntax Affinity® platform, we view the market through a wide range of thematic lenses and calculate the performance of groups of relevant companies. Themes often persist in the markets for several months, and therefore, related stocks can continually out (or under)perform. In 2022, stocks related to the Inflation, Infrastructure and Defensive themes outperformed the broader market.
Inflation. Global supply chain issues coupled with tight labor markets have driven the prices of many goods and services higher. The rising costs of food, energy, rents, autos and household goods can benefit the revenues of several groups that can pass through these costs to end customers and users. These groups include commodities, clean energy, infrastructure, real estate and royalties. In the S&P 500, Inflation-related companies rose 8.3% while unrelated companies fell 14.6%.Infrastructure. Large, multi-year infrastructure projects produce stable cash flows. The stability of these income streams is desirable in the current environment, together with the depressed valuations of the underlying companies. This contrasts with the volatile cashflows and high multiples of many growth companies. Infrastructure operators, suppliers and construction and engineering all outperformed on average last year.Infrastructure companies rose 0.9% in 2022 while unrelated companies fell14.0%.Defensives. Defensive companies, such as regulated utilities or consumer staples and certain healthcare companies, have enjoyed stable demand andreliable revenues. Their non-cyclical income streams are attractive during periods of high uncertainty or slowing growth as they offer more visible earnings. Defensives outperformed their counterparts by 13.9% in 2022.
Stocks depending on advertising revenue fell 39% on average in 2022
Stocks which depend on advertising revenues (primarily using websites and television) fared particularly poorly in 2022. Advertising revenues are highly cyclical, and investor sentiment has declined with rising recession risks.Hence, the group of stocks whose primary product revenues are derived from advertising fell -39%.Companies in this group that experienced performance headwinds in 2022include: Alphabet (-39.1%); Meta Platforms (-64.2%); Disney (-43.9%);Comcast (-28.7%); Fox (-15.8%) and NewsCorp (-17.5%).
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This document is for informational purposes only and is not intended to be, nor should it be construed or used as an offer tosell, or a solicitation of any offer to buy, any security. Additionally, the information herein is not intended to provide, and shouldnot be relied upon for, legal advice or investment recommendations. You should make an independent investigation of thematters described herein, including consulting your own advisors on the matters discussed herein. In addition, certaininformation contained in this factsheet has been obtained from published and non-published sources prepared by otherparties, which in certain cases have not been updated through the date hereof. While such information is believed to be reliablefor the purpose used in this factsheet, such information has not been independently verified by Syntax and Syntax does notassume any responsibility for the accuracy or completeness of such information. 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