Equity market dislocation and index-based investing

Jun 8th, 2020 | By | Category: Equities

By Zhen Wei, Executive Director, and Shuo Xu, Vice President, MSCI Research.

Equity market dislocation and index-based investing

Equity market dislocation and index-based investing.

During periods of heightened volatility, indexes with up-to-date constituent composition may help identify potential dislocations in global and regional equity markets, as well as various market segments, including sectors and market capitalization.

Index-level fundamental data and exploring potential market dislocations

An example of potential dislocation was reflected in the high degree of performance dispersion across various market segments for the year to date through 29 May 2020.

The exhibit below shows that, based on gross index returns, while the Chinese equity markets (benchmarked to the MSCI China A Onshore IMI Index and MSCI China IMI Index) performed the best year to date among major equity markets, they underperformed global equities (benchmarked to the MSCI ACWI IMI Index) during the past ten years.

Comparing short and long-term market performance
Performance and valuations (%)

Source: MSCI.

In such a context, fundamental data such as dividend yield, earnings growth, return on equity, leverage, price-to-earnings ratio, and other profitability/valuation metrics could provide important information when evaluating how the global market and its segments stand in absolute and relative terms.

The exhibit below shows that after the global-market sell-off during Q1 2020, the global equity market was valued below its historical mean in terms of price-to-12-month-forward-earnings ratio, as of 31 March 2020. However, this valuation metric wasn’t extremely low compared to its history.

Index valuations across market segments

Source: MSCI.

Looking to regions, market-cap size, and sectors

Fundamental data could help provide further information about potential dislocations in relative positionings. For example, based on index-level price-to-forward-earnings ratio, North America was valued around its historical average at the end of Q1 2020. The region’s valuation was expensive relative to the Pacific region, however, at 90% of its historical percentile.

Similarly, the same indicator pointed to potential undervaluation of global small caps relative to large caps, as well as the financials sector relative to communication services at the end of Q1 2020, as shown in the exhibit below.

Historical Relative Price-to-12-Month-Forward-Earnings Ratios

Source: MSCI.

Scouting for potential dislocation in currency-overlay policy

With policy rate cuts across major economies and a flight to safe-haven currencies during the Covid-19 outbreak, the return and risk impact of existing currency-overlay policy might have been affected, potentially creating a misalignment between policy and the macroeconomic environment.

We looked at the effect of currency hedging in international portfolios based on MSCI hedged indexes. Over the first quarter of 2020, US- and Japan-based investors would have gained by fully hedging their international currency exposures due to the appreciation of their domestic currencies.

On the other hand, Australia-based investors who fully hedged, statically, would have seen a reduction in return and a rise in risk over the same period. As we’ve seen in prior research, a more adaptive approach to currency hedging could serve as an alternative method.

Effect of currency hedging during Covid-19: The local investor’s perspective

Source: MSCI.

Market turbulence amid the Covid-19 crisis might have presented risks and opportunities for investors due to short-term dislocation of financial markets and market segments. During such a time, indexes, combined with an exploration of fundamental data, provided a wealth of information to help identify potential market dislocations.

(The views expressed here are those of the authors and do not necessarily reflect those of ETF Strategy.)

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