The Case for Revenue Weighting

Transcription

1 The Case for Revenue Weighting Vince Lowry Lead Portfolio Manager Oppenheimer Revenue Factor Team Executive Summary Market-cap-weighted index funds have become an increasingly popular way to gain access to a broader market. Historically, market-cap weighting has led to overexposure to trendy, overpriced sectors, industries and names. Smart beta strategies track indices that do not use the conventional market capitalization weights and instead use other factors, such as revenue, dividends or cash flow, to weight securities. Weighting securities by companies revenues has a strong track record for historically delivering better returns than market-capitalization-weighted portfolios. Revenue Weighting Outperformed Over Most Rolling Periods Percent of time revenue-weighted S&P Index outperformed S&P Index net of fees 1 ( ) 1% 8 6 8% 93% 9% 4 2 -Year 1-Year 1-Year Source: Ned Davis Research, 12/31/1. Past performance does not guarantee future results. The performance results for the revenue-weighted S&P Index represent hypothetical back-tested performance to illustrate how a revenue-weighted index may have performed. It is not intended to depict the performance of any existing index or any investment product. For Institutional Use Only Not for Use with Retail Investors Not FDIC Insured May Lose Value Not Bank Guaranteed

2 OppenheimerFunds Market-Cap Weighting Has a Number of Limitations A Look at the History The search for the best way to represent or gain exposure to the market has had two milestones: 1896 Charles Dow creates the original price-weighted stock index. For decades, it was the universally accepted concept of the market. But problems arose as stock splits and dividends threw a monkey wrench into Dow s original thinking. 197 Standard & Poor s (S&P) creates the S&P with market-cap weightings. Its methodology is broader in scope and more adaptable to stock splits, spin-offs, mergers, and other corporate action. An entire industry is built around the assumption that market capitalization delivers the best representation of the market and is the most optimal method for weighting securities. Why We Believe Market Cap Isn t Ideal Remember what market cap is: Market Cap = # of Shares Outstanding x Current Price of Each Share 1. Market capitalization is driven by the price investors are willing to pay for the shares outstanding, which at times may be unduly influenced by investor sentiment, a notoriously poor gauge of a stock s underlying value and long-term potential. 2. Overall, market-cap focused vehicles tend to overweight trendy sectors, large stocks and stocks with higher price to earnings ratios (P/E ) and underweight undervalued and out-of-favor stocks. That combination has the potential to seriously erode investors returns over time. 2

3 The Right Way to Invest 3. Market-cap weightings increase exposure to sectors as their valuations become inflated. At different points over the past 3 years, the market capitalization of certain sectors, like information technology in the late 199s and financials in the mid-2s, have soared right before they collapsed, causing investors to ride the sector exposure up and then down at inopportune times. A market-cap-weighted strategy has to rebalance its portfolio to match the new, lower capitalization of stocks after a sector experiences a major downturn and often misses out on the subsequent performance. Peaking Market Caps May Be a Bad Time to Own a Sector S&P Index: Peak Sector Weights 199s: Info Tech 2s: Financials 3% 2 1 Sector bubble forms. Next two calendar years performance (21 22): 6.18% 9% 3% 2% Bubble bursts. Next two calendar years performance (23 24): +.9% 3% 2 1 Sector bubble forms. Next two calendar years performance (27 28): 63.6% 13% 22% 9% Bubble bursts. Next two calendar years performance (29 21): % Source: Bloomberg. S&P Information Technology Index is a capitalization-weighted index that represents the performance of the GICS Level 1 Sector: Information Technology. S&P Financials Index is a capitalization-weighted index that represents the performance of the GICS Level 1 Sector: Financials. Past performance does not guarantee future results. 4. Rising or falling market weights are not the same as rising or falling investor returns. There is little evidence that market-cap weighting is an accurate measurement of the average price moves of a market. The charts below demonstrate, even though the information technology sector experienced pronounced market value expansion over the past quarter century, the returns didn t always keep up. On the other hand, the healthcare sector posted significant returns even when there was only a modest increase in market cap. Rising or Falling Market Weights Are Not the Same as Rising or Falling Investor Returns Information Technology Sector returns vs. market-cap growth (199 21) Healthcare Sector returns vs. market-cap growth (199 21) 1% 1 14% 11% 1% 1 6% 12% % Change in Market Cap Annualized Total Return % Change in Market Cap Annualized Total Return Source: Bloomberg. S&P Information Technology Index is a capitalization-weighted index that represents the performance of the GICS Level 1 Sector: Information Technology. S&P Health Care Index is a capitalization-weighted index that represents the performance of the GICS Level 1 Sector: Healthcare. Past performance does not guarantee future results. 3

4 OppenheimerFunds Fundamental Factors May Offer Better Alternatives Smart beta defines a category of investment strategies that track indices that do not use the conventional market capitalization weights. Smart beta strategies instead use other fundamental factors employing a transparent rulesbased approach. Commonly used factors include: Cash Flow Dividends Earnings Revenue Factor Weightings Outperform Market-Cap Weighting It was shown that by re-weighting 1, stocks by various fundamental factors, they outperformed market-cap weighting with an average annual performance of 2.1% from 1962 to 24, a 42-year period. 2 We re-ran the data through 21 and found similar results. (See chart on next page.) How Should Investors Determine Which Factor to Employ? What are you looking for? As we search for the best fundamental factors or combination of factors to replace market - cap weighting, it pays to ask the question: what are we really looking to accomplish? Highest possible return? Best risk-adjusted return? Lowest volatility? 1. Look to retain the benefits market-cap-weighted indices offer. Beyond the question of their performance, market-cap-weighted indices do offer investors certain benefits that you d surely want to keep if you switched to another factor. These benefits include: 1. Broad diversification. 2. Transparency of investment process. 3. A rules-based approach that removes emotion from the investing process. 4. Low cost. 4

5 The Right Way to Invest 2. Consider and compare the merits of various fundamental factors. We analyzed the returns and standard deviations of each factor from 198 to 21. We selected 198 as the start date because that is the point at which data for all factors are available. If the overall goal is to potentially outperform the traditional S&P Index with only slightly greater historical volatility of returns, then a revenueweighted portfolio may fit these objectives. In addition, historically, the revenue-weighted portfolio provided broad market exposure and also generally stable exposure to companies and sectors throughout market cycles. Is There a Better Way to Weight the S&P Index than by Market Cap? Factor Positive Attributes Alternative to S&P Index? Net Annualized Total Return (198 21) Net Annualized Standard Deviation (198 21) Cash Flow Higher allocation to companies that can pursue opportunities to increase shareholder value. Results in a deep value portfolio. 11.8% 1. Dividends Results in higher income, lower volatility portfolios. Not broadly representative of market as not every company pays a dividend. 11.6% 14.3 Earnings Results in higher quality, more value-oriented portfolios. Earnings can easily be manipulated. Not all companies generate earnings. 11.8% 14.9 Earnings can fall in recessions, resulting in investors selling companies often at lower levels. Equal Weighted Avoids increased exposure to overvalued or trendy sectors, industries or securities. Not a true large-cap alternative as it results in greater mid-cap exposure. Greater volatility of returns. 12.4% 17. Revenue Revenues are not easily manipulated. Revenues are generally more stable throughout market cycles than earnings or market cap. Broad representation of market as all companies in S&P Index generate revenue. Results in higher quality, more value-oriented portfolios. 11.9% 1.8 Sizable up capture to the S&P Index and no additional down capture.* Market-Cap- Weighted S&P Broad diversification N/A 1.8% 1.3 For illustrative purposes only. Source: Ned Davis Research, 12/31/1. * Source: Ned Davis Research, 12/1. The up capture ratio to the S&P Index of a back-tested S&P Index: Revenue-weighted is 136% vs. a down capture ratio of 99%. Past performance does not guarantee future results. The performance results for the various factor-weighted indices represent hypothetical back-tested performance to illustrate how each hypothetical factor-weighted index may have performed. It is not intended to depict the performance of any existing index or any investment product.

6 OppenheimerFunds Revenue Weighting Offers the Potential for a Combination of Compelling Benefits Weighting the companies on the basis of revenue, or the income that a company receives from its normal business activities, positions an investor to capture the core benefits of the S&P Index, such as broad exposure and transparency, without some of the limitations of the market-cap-weighted portfolios or the other factors. 1. Broad market diversification. All the companies in the S&P, as an example, generate revenue. Every S&P Company Generates Revenue Revenues 12 Months Ending 12/31/1 1 Walmart $48B 1 Northrop Grumman 24B 2 VF Corp. 13B 3 CMS Energy 7B 4 Fastenal 4B Vertex 79M Source: Ned Davis Research, as of 12/31/1. 2. Revenue generally isn t manipulated. Revenue is a straightforward metric that is extremely difficult, albeit not impossible, to manipulate without serious consequences. 3. Broad market portfolio, often at lower valuations. By not having to buy the trendy, overpriced stocks in the same way a market-cap-weighted index portfolio does, a revenue-weighted strategy often exhibits more attractive valuation characteristics. No Overweight to Trendy, Overpriced Stocks S&P Index vs. Revenue-Weighted S&P Index Valuation Metrics as of 12/31/1 2x Price to Earnings Price to Sales Price to Book Revenue-Weighted S&P Index S&P Index Source: Bloomberg, Standard & Poor s, 12/31/1. Price to Cash Flow Dividend Yield 4. Company revenues tend to be more stable than market values or earnings. In the past six annual market corrections (199, 1994, 2, 21, 22, 28), the aggregate revenues of the companies in the S&P Index grew in four of those six years. In the two years in which revenue declined, it declined by a smaller percentage than the market cap of the index. Corporate revenues tend to be more stable than earnings as well. For example, during the 28 financial crisis, the aggregate earnings in sectors like materials and industrials plunged while the aggregate revenues of those sectors actually climbed. The relative stability of revenues may prevent investors from rebalancing into smaller position sizes at the worst times. 6

7 The Right Way to Invest. Revenue weighting has historically provided smoother sector exposure over time. Market-cap-weighted benchmarks have historically had more volatile exposure to individual sectors than revenue-weighted portfolios, for which sector exposure has historically been smoother over time. Smoother Sector Exposure Over Time GICs Sector Weightings 1% Revenue Weighted 1% Market-Cap Weighted Energy Materials Industrials Consumer Discretionary Consumer Staples Source: Ned Davis Research, 12/31/ Healthcare Financials Information Technology Telecommunication Services Utilities Energy Materials Industrials Consumer Discretionary Consumer Staples Healthcare Financials Information Technology Telecommunication Services Utilities 6. A history of outperformance wasn t dependent on a few sectors. It came from a broad variety. Weighting based on revenue instead of market capitalization results in portfolios with lower average price to sales ratios across all sectors. Not surprisingly, the revenue-weighted portfolios have historically generated outperformance across all 1 GICS sectors. Less Costly and Broader Exposure with a History of Outperformance Revenue Weighting Historically Delivered Cheaper Exposure to Sectors Average price to sales ratio of revenue-weighted S&P Index sectors ( ) Revenue Weightings Historical Outperformance Comes from All Sectors Annualized performance ( ) of revenue-weighted sectors vs. market-capitalization-weighted sectors Average Price to Sales Ratio Energy Materials Industrials Average Revenue Weighted Consumer Discretionary Consumer Staples. Healthcare 2.1 Financials Sources: Bloomberg and Ned Davis Research, 12/31/1. Past performance does not guarantee future results. 4.9 Information Technology Telecommunications Utilities Average Market-Capitalization Weighted Utilities Telecommunications Information Technology Financials Healthcare Consumer Staples Consumer Discretionary Industrials Materials Energy Revenue Weighted 8.4% Annualized Return Market-Capitalization Weighted 1.6% 1.% 1.9% 9.8% 9.6% 8.4% 11.% 1.2% 9.9% 11.3% 9.% 1.4% 9.2% 13.7% 11.8% 13.4% 12.4% 14.2% 12.1% 7

8 OppenheimerFunds History Suggests the Potential Effectiveness of a Revenue-Weighted Portfolio To further examine how a revenue-weighted index performs in action, we back-tested a revenue-weighted portfolio, with the following methodology: Compared the results of all the securities in the S&P from a common start date of 1972 to the present, using a market-cap weighting and a revenue weighting. Assumed a.9% management fee for the fully passive market-cap-weighting approach. Assumed a higher fee of.49% for the revenue-weighted portfolio. The Results Speak for Themselves Over the past 42 years, the revenue-weighted portfolio delivered an extra 171 basis points (1.71%) in average annual returns, with only slightly more risk, as measured by standard deviations of returns. Over the full period, the revenueweighted portfolio nearly doubled the returns of the market-cap-weighted index. On an initial investment of $1,, that higher return translated into more than $, in additional returns. During that time, the revenue-weighted portfolio, on average, captured 136% of the S&P s upside, and 99% of the downside. A History of Outperformance for Revenue Weighting Revenue-Weighted S&P Index Outperforms S&P Index Over the Past Four Decades Growth of $1,: (net of fees) 1 Historically Capture More of the Upside and No Additional Downside $1,, 12,, Annualized Return Standard Deviation $11,911,64 136% 9,, 6,, Revenue Weighted 11.% 1.8% Cap Weighted 1.% 1.3% $6,48,47 99% 3,, Revenue-Weighted S&P Index Source: Ned Davis Research, 12/31/1. 22 S&P Index Upside Capture Downside Capture Revenue-Weighted Has Historically Beat Market-Cap Weight Over Long-Term Periods Historically Revenue Weighted Outperforms Over Most Rolling Periods % of time revenue-weighted S&P Index outperformed S&P Index net of fees 1 ( ) 1% % 3-M 8% 74% 6% 6% 6-M 1-Yr 3-Yr -Yr Rolling Monthly Returns 93% 9% 1-Yr 1-Yr When viewed over the time horizons that long-term investors might own a portfolio three years or more revenue-weighted portfolios consistently beat market-cap weighting. Source: Ned Davis Research, 12/31/1. Point to note: The only observed period during which -year results for the revenue-weighted index significantly underperformed was the mid- to late-199s, during the run-up in valuations of technology stocks. 8

9 The Right Way to Invest Recognizing When a Revenue-Weighted Portfolio Could Underperform It is reasonable to expect underperformance during a period when a single sector or industry significantly outperforms, like the late 199s tech bubble when markets were less driven by fundamentals. Five-year excess returns also tend to converge toward zero as the economy enters recession as the inherent bias to low margin businesses (high revenue, high cost of business) compresses returns during periods of economic weakness. Periods When a Revenue-Weighted Portfolio Has Been Vulnerable When has it been vulnerable? 1. At the beginning of an economic downturn, inherent bias to low margin businesses. 2. When there is excess in individual sector or industry. Rolling Monthly -Year Returns Net of Fees: Revenue-Weighted S&P Index vs. S&P Index 6% Revenue-Weighted Outperformed Recession 1991 Recession The Tech Bubble 28 Recession (For extra detail, see chart on top of page 3) Market-Cap Weighted Outperformed Source: Ned Davis Research, 12/31/1. It s Important to Examine All the Circumstances that Might Deliver Short-Term Underperformance Over shorter investment horizons, there have also been instances when the revenue-weighted S&P underperforms. That happened during the financial crisis of 28, but not for the reason one would expect. Underperformance During the 28 Financial Crisis Provided a Beneficial Result Rolling Monthly 1-Year Returns of the Revenue-Weighted S&P Index vs. S&P Index 1 (Net of Fees) January 31, 28 Sector Exposure Financials and Consumer Discretionary 1% 1 Revenue-Weighted Outperformed Financial Crisis Market-Cap-Weighted Outperformed 2% % 1.8% 18.6% 8.8% It wasn t an overweight to financials, but rather one to consumer discretionary stocks, that caused the temporary underperformance Revenue Weighted Market-Cap Weighted Financials Consumer Discretionary Source: Ned Davis Research, 12/31/1. 9

10 OppenheimerFunds Explaining the Relative Performance in 28 and 29 Using the Ford Motor Company as the Case Study During the 28 Financial Crisis: Ford s Revenues Fell by 7% Ford s Market Cap Fell by 64% $2M $2B $172 1 $161 1 $ $ Revenues Market Cap Jan-8 Dec-8 Jan-8 Dec-8 The revenue-weighted S&P began 28 with a significantly higher weighting to consumer discretionary stocks like Ford Motor Company. When Ford s market cap fell by 64%, its weighting in the S&P Index declined to a very nominal level. Ford s revenues fell by 7%, causing the revenue-weighted portfolio to rebalance to a lower but still relatively substantial weighting. After the Crisis (29) Monthly Rolling 1-Year Return Spread Between Revenue and Market-Cap-Weighted Indices. 1% 1 29 Returns Revenue Weighted % Market-Cap Weighted % The Consumer Discretionary sector, including Ford Motor Company, rebounded in 29. Investors: In revenue-weighted portfolios participated in the rebound. In market-cap-weighted portfolios did not participate as much in the upturn Sources of all chart data on this page: Ned Davis Research and Bloomberg, 12/31/1. 1

11 The Right Way to Invest How Does a Revenue-Weighted Strategy Fit into an Overall Portfolio? History Suggests It Could Enhance Returns and Improve Diversification The true test of an investment portfolio is how it behaves in combination with the other holdings in a client s portfolio. We use 1978 as our start date because that is when the small- and mid-cap indices were formed. The evidence suggests a revenue-weighted investment has historically complemented other holdings well. Revenue-Weighted Strategy Have Historically Performed Well in an Overall Portfolio What Happened If You Replace Market-Cap Weighted S&P with Revenue-Weighted S&P? Forty-years: 1978 to 21 Sample Portfolio A Market-Cap Weighted for Large-Cap Sample Portfolio B Revenue-Weighted for Large-Cap Market-Cap Weighted S&P Index n Large-Cap 6% n Mid-Cap 2% n Small-Cap 2% Revenue Weighted S&P Index n Large-Cap 6% n Mid-Cap 2% n Small-Cap 2% Sources: Ned Davis Research and FactSet, 12/31/1. Mid-cap stocks are represented by the Russell Mid Cap Index. Small-cap stocks are represented by the Russell 2 Index. Past performance does not guarantee future results. Impact of Switching to Revenue Weighting for Large Cap Market-Cap Weighted Revenue Weighted Portfolio Annualized Return Historically provided higher returns Portfolio Annualized Standard Deviation Historically provided slightly more volatile returns Sharpe Ratio Historically provided better risk-adjusted returns Average P/E Historically provided a lower overall valuation Dividend Yield Historically provided higher yields 12.11% 13.6% x 17.2x 2.1% 2.7% Sources: Ned Davis Research and Bloomberg, 12/31/1. 11

12 A Better Alternative Market-cap-weighted index funds have become very popular recently. While they offer a number of positive attributes, they do have certain limitations: Increasing market capitalization is not always a good indicator of a stock s or a sector s future performance. Market-cap weightings can also leave investors overexposed to trendy and overpriced stocks. Re-weighting indices based on fundamental factors, like revenue, may enable investors to earn both higher returns and better returns on a risk-adjusted basis. Choosing a revenue-weighted strategy enables investors to enjoy considerable benefits: 1. Broad market diversification. 2. A low cost, transparent and rules-based investment approach. 3. A track record of better long-term returns. 4. Ability to buy the winners cheaper. Vince Lowry Lead Portfolio Manager, Oppenheimer Revenue Factor Team Visit Us oppenheimerfunds.com Call Us Returns are net of fees using an expense ratio of.49% for S&P Index revenue weighted and.9% for S&P Index. Expense ratios were determined by the current expense ratio of OppenheimerFunds Large-Cap Revenue ETF (.49%) and SPDR S&P ETF Trust (.9%), the most commonly held ETF in the world. Past performance does not guarantee future results. 2. Source: Rob Arnott, Jason Hsu and Philip Moore, Fundamental Indexation. Journal of Finance, 2. The Russell Mid Cap Index is a market-capitalization-weighted index designed to represent the performance of U.S. mid-cap stocks. The Russell 2 Index is a market-capitalization index designed to measure the performance of small-cap stocks. Indices are unmanaged and cannot be purchased directly by investors. These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are subject to change based on subsequent developments. Alternative weighting approaches (i.e., using revenues as a weighting measure), while designed to enhance potential returns, may not produce the desired results. The data provided by Ned Davis Research regarding the revenue-weighted S&P Index is for informational purposes only and is not intended to depict the performance of any existing index or any investment product. All performance results for the revenue-weighted S&P Index are based on criteria applied retroactively with the benefit of hindsight and knowledge of factors that may have positively affected its performance. OppenheimerFunds, Inc. makes no warranties, express or implied, concerning the accuracy, completeness, reliability, suitability or timeliness of the information provided by Ned Davis Research. Shares of Oppenheimer funds are not deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC or any other agency, and involve investment risks, including the possible loss of the principal amount invested. Before investing in any of the Oppenheimer funds, investors should carefully consider a fund s investment objectives, risks, charges and expenses. Fund prospectuses and summary prospectuses contain this and other information about the funds, and may be obtained by visiting oppenheimerfunds.com or calling Investors should read prospectuses and summary prospectuses carefully before investing. For Institutional Use Only. This material has been prepared by OppenheimerFunds Distributor, Inc. for institutional investors only. It has not been filed with FINRA, may not be reproduced and may not be shown to, quoted to or used with retail investors. Oppenheimer funds are distributed by OppenheimerFunds Distributor, Inc. 22 Liberty Street, New York, NY OppenheimerFunds, Inc. All rights reserved. DM March 1, 216