Risk of Indexing

MaxiRobriguez · 12 June 2019 at 10:41AM

Does anyone actually consider the risk of index funds when investing? The default response on here, and in other places as well, as that indexing is the sure-fire way to reduce risk primarily because of diversification.

But the growth in passive investing is focused on market cap indexing, which is exponentially increasing the price of the largest capitalised compared to the 'smaller' companies also part of the index. The phenomena is quite obvious just by looking at the price trajectory of Apple and Microsoft against the S&P500 in general. Actively managed funds have used this as a play too. US active funds for example contain holdings which are dominated by .... Apple, Microsoft and the other large caps... which in turns increases the allocation to these in passive funds...

In a sustained market downturn we'd usually expect flight to safety. Buy the large caps - it'll protect your portfolio. But with the growth of passive investing which has really taken off in the past ten years since the last recession, is that tactic going to end up increasing losses rather than reducing, if large caps see a bigger decline because of the reversal of catch22 buying as per above?

Interested to hear peoples thoughts, and whether they consider the performance of index investments in potential future bear markets?

Prism · 12 June 2019 at 11:00AM

If we take the S&P as an example you typically find that many of those large caps justify their share price increase. In earnings terms the current price is pretty much in line with what it has been for much of the last 20 years. So I doubt the index is in a particularly worse position than it was during the last two bear markets.

eskbanker · 12 June 2019 at 11:04AM

MaxiRobriguez wrote: »

But the growth in passive investing is focused on market cap indexing, which is exponentially increasing the price of the largest capitalised compared to the 'smaller' companies also part of the index. The phenomena is quite obvious just by looking at the price trajectory of Apple and Microsoft against the S&P500 in general.

Obviously growth in market cap within larger companies will inherently have a greater effect on a cap-weighted index than smaller ones, but why 'exponential'?

El_Torro · 12 June 2019 at 11:10AM

I would say that you're correct, essentially the faster they grow the faster they could also potentially fall.

We won't know for sure what the effect of all this passive investing will be until the next crash, though if say, we get another crunch and shares drop by 50%, where will active investors go? Will people go to smaller companies or will they stick to the big caps in the hope that they will recover?

Also, what's the alternative? Should the more savvy among us be investing in defensive actively managed funds? Many tried doing that with Woodford and look at the state of his funds at the moment. Though I guess we could argue that the concept is sound, he's just made some very bad decisions.

Personally I think that, as always, time in the market is key. Passive funds will still recover after a crash. Some defensive funds will profit from a crash comparatively, though the difficult part is deciding today which of the defensive funds will perform best at the time.

MaxiRobriguez · 12 June 2019 at 11:56AM

Prism wrote: »

If we take the S&P as an example you typically find that many of those large caps justify their share price increase. In earnings terms the current price is pretty much in line with what it has been for much of the last 20 years. So I doubt the index is in a particularly worse position than it was during the last two bear markets.

Yes, obviously not gone as far as to talk about earnings growth potentially being higher in the large caps but primarily due to index investing not really caring about that.

eskbanker wrote: »

Obviously growth in market cap within larger companies will inherently have a greater effect on a cap-weighted index than smaller ones, but why 'exponential'?

Perhaps bad wording but on the basis of the positive reinforcement between active/passive which is seeing greater allocation to large cap.

El_Torro wrote: »

I would say that you're correct, essentially the faster they grow the faster they could also potentially fall.

We won't know for sure what the effect of all this passive investing will be until the next crash, though if say, we get another crunch and shares drop by 50%, where will active investors go? Will people go to smaller companies or will they stick to the big caps in the hope that they will recover?

Also, what's the alternative? Should the more savvy among us be investing in defensive actively managed funds? Many tried doing that with Woodford and look at the state of his funds at the moment. Though I guess we could argue that the concept is sound, he's just made some very bad decisions.

Personally I think that, as always, time in the market is key. Passive funds will still recover after a crash. Some defensive funds will profit from a crash comparatively, though the difficult part is deciding today which of the defensive funds will perform best at the time.

Yeah agreed, not saying it's a long term risk, and actually I'm focusing on my own portfolio here which is dominated by index funds, and wondering about reallocation options. I carry a fairly sizeable chunk of cash which I use as dry powder pounce opportunities but now wondering about the convergence in my index funds which is reducing my diversification (albeit, as stated above, active funds aren't any better so might be limited choice!)

Tom99 · 12 June 2019 at 12:36PM

Won't it depend on how much of an index is owned by tracker funds.
For example how much of HSBC/BP/GSK etc is owned by tracker funds?

bostonerimus · 12 June 2019 at 2:02PM

Market cap indexing isn’t perfect and won’t give to the maximum possible return, but given the alternatives I think it’s the best option for the retail investor.

Scarpacci · 12 June 2019 at 3:23PM

I'm not sure indexing is responsible for the size of these tech companies. I think anti-trust activity, or the lack thereof, and growing benefits of scale, particularly in the tech sector, which used to be a disadvantage.

Most of those companies have large market caps by virtue of selling large amounts of products, rather than "irrational exuberance" in valuation. The multiple on Apple is notably lower, rightly or wrongly, than companies selling shampoo and dog food. The company had $265bn of revenue last year and has $66bn of cash and investments on its balance sheet. It's not really a story of investors, either active or passive, bidding it up to crazy levels.

Microsoft is certainly more highly-valued than it was six years ago, but I think the active participants in the market would point to its growing cloud business under better management. The passive funds merely follow the logic, sound or otherwise, of those who still perform price discovery.

There might be something to the idea that eventual index outflows would lead to bigger drops for the major index constituents. I think that's always been true, though. When markets start dropping, the big participants start selling their most liquid holdings first. You usually see the defensive, easily traded stocks fall first, counter intuitively, at the start of bear markets.

seacaitch · 12 June 2019 at 3:53PM

MaxiRobriguez wrote: »

But the growth in passive investing is focused on market cap indexing, which is exponentially increasing the price of the largest capitalised compared to the 'smaller' companies also part of the index.

Sorry, but this statement isn't correct.

Cap-weighted index funds function by holding the same percentage of each index constituent's shares. So, a given index tracking fund that owned 3% of a cap-weighted index the would own 3% of the largest constituent's shares, 3% of the smallest constituent, and 3% of every constituent in-between. If that index fund experienced cash inflows that served to raise its overall ownership of the index to, say, 4%, then after deploying the cash it'd own 4% of the outstanding shares of every constituent.

The relative sizes of the index constituents are unaffected by inflows/outflows from the index fund itself, because purchases or sales by the tracker always occur in mkt cap-weighted proportions.

Clearly, the relative size of the index constituents do change, but that's due to things other than the inflows/outflows from cap-weighted trackers of the index, eg:
- from buying/selling of constituents by regular active investors;
- from buying/selling by trackers of other indexes that happen to include some but not all of our cap-weighted index's constituents. NB this is an increasingly important effect.

Both of the above could result in the valuations of the largest companies growing faster than the smallest, some of this entirely rational and justified by fundamentals, but also some not eg:
- the largest might be beneficiaries of an irrational momentum effect if they are the leading names in a current (but temporary) investment theme/fad; cf. every mkt bubble top
- liquidity requirements may drive some funds (whether they be regular active funds or increasingly funds tracking an index other than our cap-weighted index) into holding only the largest cap businesses from our index (while ignoring the rest of the constituents), with their inflows thereby disproportionally growing the valuations of the largest caps vs the smaller caps in our cap-weighted index
- etc.

These latter examples might be the sort of thing you're thinking of, particularly the second example, as they might feasibly be giving rise to (temporarily) inflated valuations for the largest businesses that perhaps the actions of active investors aiding price discovery cannot yet negate. In a prolonged downturn, it might be expected that outflows from the themed/fad funds mentioned above, or from the liquidity-constrained funds that target only the largest cap stocks, might fully reverse this valuation growth effect.

Risk of Indexing

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