IS THERE AN INDEXING BUBBLE?

By David Stein from Moneyfortherestofus.com

03 July 2017

The Popularity Of Index Investing

Passive index funds and ETFs are investment vehicles that seek to replicate the performance of a target segment of the financial markets such as the U.S. stock market.

These indexing strategies have become extremely popular.

The World’s Largest Mutual Funds and ETFs

Ten of the eleven largest mutual funds and ETFs in the world are passive index funds. The two largest, which combined have over $400 billion in assets, seek to replicate the performance of the S&P 500 Index, a measure of U.S. large company stocks.

A total of five of the top eleven funds/ETFs track the S&P 500 Index, while four others track the overall U.S stock market but have the vast majority of their assets invested in stocks that comprise the S&P 500 Index.

The S&P 500 Index is a capitalization weighted index, which means a stock’s weight in the index is based on its size as measured by price times the number of shares outstanding.

The top ten holdings in the S&P 500 Index comprise 19% of the benchmark while the top five holdings (Apple, Microsoft, Amazon, Johnson & Johnson and Facebook) make up 10%.

Effectively, nine of the eleven largest mutual funds and ETFs in the world are concentrated in a handful of very large companies.

Active Funds

Actively managed mutual funds and ETFs seek to outperform a market benchmark such as the S&P 500 Index by having different weights than the index.

The largest actively managed mutual fund in the world is the Fidelity Contrafund with $115 billion of assets under management. It is number fifteen on the list of the world’s largest funds/ETF.

What active bet is the fund making? It is doubling down on the largest companies in the S&P 500 Index. The Fidelity Contrafund’s top seven holdings, which comprise 30% of its assets, are all top ten holdings in in the S&P 500 Index.

Even the global stock market is skewed toward the biggest U.S. companies. The MSCI All Country World Index contains 2,746 holdings spread across 23 developed markets and 23 emerging market countries. MSCI states “the index covers approximately 85% of the global investable equity opportunity set.”

Yet, that index is 52% allocated to the U.S. and its top 9 holdings, which comprise 9% of the index, are the same top holdings in the S&P 500 Index.

Why Passive Investing Is Efficient

Passively investing in a market capitalization weighted index is extremely efficient because costs are low. For example, annual management fees for the iShares S&P 500 Index are 0.04%, which equates to four cents per year for every $100 invested.

In addition, because the index holdings are weighted by size, funds and ETFs that seek to replicate a market capitalization weighted index can keep trading costs low because they don’t need to rebalance their holdings on day-to-day basis to keep the weightings in line with the index as they would if they were trying to keep each holding weighted equally.

Mutual funds need to do some rebalancing due to cash inflows and outflows, but ETFs don’t have turnover related to cash flows due to the unique way new shares are created and redeemed.

Holdings Turnover

All passive index funds and ETFs have some turnover that incur trading costs as the index providers add and drop names from the underlying index. For example, the turnover in the MSCI All Country World Index was 2.7% in the past year. The turnover in the S&P 500 is about 4% per year.

Over time that holdings turnover can add up on a cumulative basis. Morgan Stanley’s Adam Parker in a 2015 research note titled “Why Is Active Management So Difficult?” wrote about the S&P 500 Index that “While there has been relatively less turnover lately, with only 3% of the companies changing since 2013, the cumulative effect of adding and subtracting companies is surprisingly substantial. Ten percent of the companies in today’s index are different since 2011, 17% are different since 2009, and fully half the companies are different since 1999.”

Passively investing in a market capitalization weighted index has become so popular because active managers as a group have underperformed the market indices and even those that have outperformed have not done so consistently.

S&P Dow Jones recently released a study that showed that of the actively managed mutual funds that were in the top quartile of their peers for the five years ending March 2012, only 22.4% remained in the top quartile five years later.
In order to outperform a market capitalization weighted benchmark, an active manager needs to structure a portfolio that differs from the index by overweighting some holdings and underweighting others with those overweights and underweights collectively delivering excess returns after deducting management fees and trading costs.

The Arithmetic of Active Management

Nobel Laureate William F. Sharpe pointed out in a 1991 piece titled “The Arithmetic of Active Management” that “over any specified time period, the market return will be a weighted average of the returns on the securities within the market, using beginning market values as weights.”

That means the return of the S&P 500 Index is comprised of the contributions of each underlying stock’s performance weighted by its size.

Sharpe continues, “Each passive manager will obtain precisely the market return, before costs. From this, it follows (as the night from the day) that the return on the average actively managed dollar must equal the market return.”

“Why? Because the market return must equal a weighted average of the returns on the passive and active segments of the market. If the first two returns are the same, the third must be also.”

In other words, a market index’s return is driven by the returns of the underlying holdings which in turn is driven by the buy, sell and hold decisions of investors. Since indexing investors match the index return before fees, that means active managers collectively must also match the index before fees.

Because active managers have higher management fees and higher trading costs than passive managers, active managers end up doing worse than index fund investors.

It is possible that professional money managers could as a group outperform the market if active retail investors picking individual stocks did far worse than professionals.

Or professional investors could outperform the market as a group if the index used to represent the market was too narrowly defined and professional investors were able to pick outperforming stocks that weren’t part of the capitalization weighted index.

As an investment advisor, I found active U.S. large company managers as a group did better relative to the S&P 500 Index during periods when middle sized companies were doing better because many of those companies weren’t part of the S&P 500 Index.

Despite these theoretical exceptions, active managers have not outperformed capitalization weighted indices, which means indexing strategies will continue to increase in popularity.

An Opportunity For Individual Investors

And as they do, that means the largest stocks in U.S. and global stock market indices will continue to increase in price, becoming more overvalued. This could create an opportunity for individual investors to outperform capitalization weighted indices if they build portfolios with smaller average market capitalizations and lower valuations than the major indices while keeping their trading costs low.

This post was originally published at Moneyfortherestofus.com. You can listen to the podcast episode below.