How do trackers deal with a falling company?

El_Torro

I've been thinking about the nature of equity trackers and just wondering what happens when a company starts losing value, and eventually goes bust.

To illustrate the point let's take a tracker as an example. The one I'd like to use for this example is Vanguard US Equity Index. A handy link: https://www.hl.co.uk/funds/fund-discounts,-prices--and--factsheets/search-results/v/vanguard-us-equity-index-income

To keep things simple let's use a company as an example. So let's use Apple. As of this writing the HL factsheet states that this fund has 2.82% of its value in Apple.

So let's say that Apple goes bust tomorrow. I guess that Vanguard's US Equity Index fund will drop in value by 2.82% and then continue as normal. Correct? I appreciate that Apple going bust would have some pretty big repercussions for the rest of the market but that's not the question I'm asking at the moment.

Let's say that instead Apple starts falling in value. Let's say that instead of 2.82% of the US stock market (or whatever it is if Vanguard's percentage isn't accurate) it drops by 20% every year for the next 5 years, eventually going bust.

So how does this fund (or any other tracker) deal with this? Will they keep their holdings in Apple and watch the value go down? I guess if I put £100 of new money in this tracker when Apple is 2% of the market, instead of 2.82%, they will just buy £2 worth of Apple shares with the money instead of £2.82?

To ask it a different way, assuming Vanguard US Equity Index receives no new money and nobody withdraws any money from the fund during the 5 years that Apple's stock is declining, the £172 million (2.82% of Vanguard US Equity Index's current value) that is currently in Apple will just continuously decline over the 5 years and eventually all be lost once the company goes bust.


I have some follow up questions about how dividends are reinvested but I think I've rambled on long enough for now. Please discuss

Voyager2002

I think your analysis is correct in the case of a cap-weighted index. Why should it be any different? After all, if Apple were to lose 20 per cent of its value in a year many pundits would see a lot of room for it to bounce back, an opportunity that the tracker fund should take.

greatkingrat

The simple answer is they don't do anything. Some companies will go up, some will go down, either way the whole point of a tracker is they just track the market. The only point anything would happen is if the value falls low enough for the company to fall out of whatever index the tracker is tracking, in which case they would have to sell the shares for whatever remaining value there was.

El_Torro

Voyager2002 wrote: »

I think your analysis is correct in the case of a cap-weighted index. Why should it be any different? After all, if Apple were to lose 20 per cent of its value in a year many pundits would see a lot of room for it to bounce back, an opportunity that the tracker fund should take.

Conversely if we know that the company is on its way to go bust then a tracker won't try to save what money they have left in the company and just leave it invested until it's all gone. Then again, how often do we definitely know that a company is going to go bust before it's too late to salvage what funds we have in it?

I guess this comes back to the argument of trackers vs managed and why one form of investing is better than the other.

greatkingrat wrote: »

The simple answer is they don't do anything. Some companies will go up, some will go down, either way the whole point of a tracker is they just track the market. The only point anything would happen is if the value falls low enough for the company to fall out of whatever index the tracker is tracking, in which case they would have to sell the shares for whatever remaining value there was.

Yes, one of the reasons why I'm not very comfortable with a FTSE 100 tracker, or S&P 500, or similar. I think a more encompassing fund is more suitable, especially for trackers.

AnotherJoe

Voyager2002 wrote: »

I think your analysis is correct in the case of a cap-weighted index. Why should it be any different? After all, if Apple were to lose 20 per cent of its value in a year many pundits would see a lot of room for it to bounce back, an opportunity that the tracker fund should take.

Tracker funds dont take "opportunities". Terry Smith or Neil Woodford or Warren Buffet might, the tracker fund wont do anything because the shares they already hold will automatically be worth 2.82% x 80% in year one, and 2.82% x 0.64 the next year and so on, until Apple falls out of the index and which point they will sell their Apple shares and buy Acme, who are replacing them.

barnstar2077

AnotherJoe wrote: »

Tracker funds dont take "opportunities". Terry Smith or Neil Woodford or Warren Buffet might, the tracker fund wont do anything because the shares they already hold will automatically be worth 2.82% x 80% in year one, and 2.82% x 0.64 the next year and so on, until Apple falls out of the index and which point they will sell their Apple shares and buy Acme, who are replacing them.

<Furiously googles Acme> FOMO

Reed_Richards

El_Torro wrote: »

, one of the reasons why I'm not very comfortable with a FTSE 100 tracker, or S&P 500, or similar. I think a more encompassing fund is more suitable, especially for trackers.

But a tracker for, say, the FTSE All-Share index does not own every share of which the index is comprised, it tries to own a representative selection (weighted with regard to market cap.). This means that the tracker fund manager could get caught out by an up-and-coming share that they failed to spot and so were underweight in.

El_Torro

Reed_Richards wrote: »

But a tracker for, say, the FTSE All-Share index does not own every share of which the index is comprised, it tries to own a representative selection (weighted with regard to market cap.). This means that the tracker fund manager could get caught out by an up-and-coming share that they failed to spot and so were underweight in.

Trackers are far from perfect. What I was saying in that post though was that if I have a FTSE 100 tracker then in theory if a company falls from being the 100th biggest company in the index to being the 101st biggest company then the fund manager will sell all the fund's holdings in that company, regardless of whether that company is likely to bounce back or not.

At least with a FTSE All Share tracker we don't see these kind of anomalies since the fund manager is tracking 500 or so companies instead of just 100. If a company falls off the index here then the impact is going to be a lot less.

Ultimately I'm not sure it makes that big a difference. A FTSE All Share tracker will (rightly) be very heavily invested in the FTSE 100 anyway so the overall effect on the fund of the smaller companies may be minimal.

Also to your point that a tracker will miss fast growing companies, I think an All Share tracker will spot this sooner and when it rebalances it will invest in that company sooner than if it was just a FTSE 100 tracker.

I don't think the bigger trackers own a selection of funds anyway. They'll own all the top companies in the index (top 100, top 500, whatever...) in representative proportions. If they were only owning a selection of companies then we're moving into managed territory, not tracked.

bostonerimus

People are too focused on "opportunities". If you want that choose your favourite active fund or get into share dealing. Index trackers are boring, which is good. Stop worrying about "anomalies" and single companies and enjoy the safety of the heard.

Thrugelmir

El_Torro wrote: »

I've been thinking about the nature of equity trackers and just wondering what happens when a company starts losing value, and eventually goes bust.

To illustrate the point let's take a tracker as an example. The one I'd like to use for this example is Vanguard US Equity Index. A handy link: https://www.hl.co.uk/funds/fund-discounts,-prices--and--factsheets/search-results/v/vanguard-us-equity-index-income

To keep things simple let's use a company as an example. So let's use Apple. As of this writing the HL factsheet states that this fund has 2.82% of its value in Apple.

So let's say that Apple goes bust tomorrow. I guess that Vanguard's US Equity Index fund will drop in value by 2.82% and then continue as normal. Correct? I appreciate that Apple going bust would have some pretty big repercussions for the rest of the market but that's not the question I'm asking at the moment.

Let's say that instead Apple starts falling in value. Let's say that instead of 2.82% of the US stock market (or whatever it is if Vanguard's percentage isn't accurate) it drops by 20% every year for the next 5 years, eventually going bust.

So how does this fund (or any other tracker) deal with this? Will they keep their holdings in Apple and watch the value go down? I guess if I put £100 of new money in this tracker when Apple is 2% of the market, instead of 2.82%, they will just buy £2 worth of Apple shares with the money instead of £2.82?

To ask it a different way, assuming Vanguard US Equity Index receives no new money and nobody withdraws any money from the fund during the 5 years that Apple's stock is declining, the £172 million (2.82% of Vanguard US Equity Index's current value) that is currently in Apple will just continuously decline over the 5 years and eventually all be lost once the company goes bust.


I have some follow up questions about how dividends are reinvested but I think I've rambled on long enough for now. Please discuss

A company in decline will ultimately be discarded from the index which is being tracked. The point of trackers is that you need not worry which company might go bust. As your overall exposure will be relatively small. Conversely you are unlikely to have a small cap stock such as an early stage Fevertree in the fund. Therefore will not benefit from an exceptional growth period.

Reed_Richards

El_Torro wrote: »

Trackers are far from perfect. What I was saying in that post though was that if I have a FTSE 100 tracker then in theory if a company falls from being the 100th biggest company in the index to being the 101st biggest company then the fund manager will sell all the fund's holdings in that company, regardless of whether that company is likely to bounce back or not. .

In theory yes, but in practice this is a judgement call for the fund manager. He/she might also choose to invest in shares that are "bubbling under" the top 100. But look at the huge variation in market caps between those companies at the top of the FTSE100 and those at the bottom and you'll see then that it makes very little difference what happens at the bottom.