Insights

A Letter From Our CIO: Systematic Equity Update

Equity markets continue their robust rally in 2024, despite a protraction of further Fed rate cuts and ongoing economic uncertainty. Against the backdrop of shifting market dynamics, we believe that our process, platform, and integrated team position us well to address the ever-evolving needs of our clients.

July 25, 2024

John A Tucker, CFA

CIO, Systematic Equity

Equity markets continue their robust rally in 2024, despite a protraction of further Fed rate cuts and ongoing economic uncertainty. Against the backdrop of shifting market dynamics, we believe that our process, platform, and integrated team position us well to address the ever-evolving needs of our clients.

Noteworthy Happenings in Equity Indexing

Over the last six months we have also witnessed interesting side effects from the frothy equity market. For example, the concentrated nature of the rally has shined a light on certain cap-weighted index methodologies, in particular sector indexes and name-constrained indexes that have guardrails in place to ensure compliance with IRS diversification rules. These guardrails, designed to safeguard investors, ironically have been the cause for a few substantial index rebalances which have resulted in additional trading costs incurred to the funds that track them. Furthermore, persistently higher interest rates associated with the strong economy have negatively impacted the cost of index futures contracts, a primary tool for cash equitization in index funds. This development has also served as a catalyst to reevaluate the optimal amount of cash to maintain for balances as well as the most efficient instrument used to equitize that cash.

Unrelated to the strong market, it is also worth noting that US trade settlement period moved from a T+2 to T+1 settlement in May. This is a generally welcome change for investors, but one which has implications for global strategies which may include countries with misaligned settlement cycles.

Fortunately, our systematic equity portfolio management team is one of the most experienced in the industry and is supported by a global trading team that transacts over $2 Trillion in notional value. As a result, the team continues to deliver the most efficient indexed products on the market with over 99% of our portfolios tracking within their assigned tolerance band.

What We Are Hearing From Clients

Client needs are ever-evolving and the nature of our engagements continue to change. However, over the last six to twelve months, overwhelmingly, we have received consistent client inquiries on three topics in particular:

Emerging markets, and more specifically, China
US large cap performance concentration
Liquid real assets

While emerging markets (EM) equities have underperformed developed market (DM) equities in recent years, the case for investment remains strong in EM both as an opportunity to generate alpha and to take advantage of high relative economic and demographic growth rates. We have engaged with numerous clients on how best to approach the asset class from an active/passive perspective. Furthermore, as the weight of China within EM has expanded in parallel with the country’s geopolitical tensions,, more clients have been seeking guidance on the treatment of China. Generally speaking, we have found clients in one of three camps in this conversation on China:

Seeking explicit divestment options
Seeking alpha within China
Seeking control over the weight of China within their EM allocations

As a result of these discussions we continue to see flows into our Emerging Markets Equity and Emerging Markets Ex-China Equity Strategies.

With regard to US equities, as mentioned earlier, the somewhat concentrated, AI-driven rally has caused many clients to question the nature of their US large cap core index allocations and in particular whether or not a cap-weighted approach is still optimal from a diversification perspective. While there is a case to be made for alternative weighting schemes, it has been a perennial challenge to beat the cap-weighted index. Correspondingly, most institutional clients have cap-weighted policy benchmarks and to replace a cap-weighted strategy for that part of the allocation would constitute a substantial active bet--one that has not paid off for many years. For these reasons, we have seen continued inflows into core, cap-weighted US large cap equity exposures and relatively limited interest in alternatives such as equal-weighted and factor strategies.

Finally, liquid real assets such as listed exposures to REITs, commodities, infrastructure, and natural resources, have been of great interest to clients recently. Given the inflationary environment that dominated in 2022 and has somewhat persisted (despite predictions of easing inflation) to present, clients continue to show interest in these strategies as liquid and cost-effective exposures to inflation hedging assets.

The last point worth mentioning here from a trend perspective, is that clients are looking for additional means to enhance their index allocations in alternative ways. One of those is by way of lending, where we have seen almost a two-fold increase in client allocations to lending vehicles in less than 10 years. Lending has become a terrific way for clients to enhance their index return profile without materially impacting the risks associated with their investment. The other method is by way of crossing, where State Street Global Advisors leverages its own internal liquidity in order to mitigate external transaction costs and implicit market impact. In 2023 we crossed over $100 billion in equity securities and saved clients an estimated $35 million in trading costs.

Closing Thoughts

While market dynamics change and client interests evolve, we have structured the team in an agile way to optimally support our clients and to deliver results. Our focus remains to provide a broad menu of products to our clients with the tight tracking across the entire suite. However, as our clients demand more bespoke solutions, our platform has evolved to engage those conversations and support those needs. In the meantime, we appreciate the responsibility entrusted in us, and we look forward to advancing relationships as a trusted partner and solutions provider for our clients.

Disclosure

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Important Information

The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.

Investing involves risk including the risk of loss of principal.

The views expressed are the views of John Tucker through July 10, 2024 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.

Companies with large market capitalizations go in and out of favor based on market and economic conditions. Larger companies tend to be less volatile than companies with smaller market capitalizations. In exchange for this potentially lower risk, the value of the security may not rise as much as companies with smaller market capitalizations.

Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations. Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.

There are risks associated with investing in Real Assets and the Real Assets sector, including real estate, precious metals and natural resources. Investments can be significantly affected by events relating to these industries.

Investing in REITs involves certain distinct risks in addition to those risks associated with investing in the real estate industry in general. Equity REITs may be affected by changes in the value of the underlying property owned by the REITs, while mortgage REITs may be affected by the quality of credit extended. REITs are subject to heavy cash flow dependency, default by borrowers and self-liquidation. REITs, especially mortgage REITs, are also subject to interest rate risk (i.e., as interest rates rise, the value of the REIT may decline).

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