Let's step back a little and look at their construction and the emergence of index investing. Equity indices have been amply researched because they have been around for some time so this article will restrict itself to them.
Investing today can take many forms but increasingly consists in buying the market
Investing in the 19th century meant becoming a shareholder in companies which were considered to have interesting businesses, prospects and results. Investing today can take many forms but increasingly consists in buying the market, an approach which is infinitely more short term than that adopted by our great grandparents. It is a commendable goal but if indices make the simple and attractive promise to represent the market, do they really reflect what they are supposed to?
A little history lesson
In 1896, two New York-based journalists, Charles Dow and Edward Jones, hatched the novel idea of representing the US stock market with an index. Its construction was simply the 30 stocks weighted by their unit price and the index featured one share of each company. It had strong construction bias because, apart from the initial accent on creating an index to reflect the new industrial economy, a share price bears little resemblance to a company’s actual economic situation. Their approach also favoured companies with high unit share prices. The Dow Jones is a strange beast, an unquestionably subjective representation of the US stock market.
"Did you know that there are now more indices than listed stocks?"
The 1950s saw the arrival of the S&P500 index which ushered in a new form of index construction which weights stocks for their market cap and their free float. It remains the most popular format and most of the European indices created in the 1980s use the same model. Indices have become so important in recent years that the only conceivable way of describing moves on national markets is to cite their flagship index.
And yet market cap-weighted indices also have some bias, especially if the index comprises only a limited number of stocks. For example, Switzerland’s SMI is heavily influenced by Nestlé’s performance while France’s CAC 40 tends to move in line with shifts in luxury stocks or Total.
Like the Dow Jones, market cap-weighted indices have their own bias and act as pro-cyclical tools. Before the tech bubble burst at the beginning of the 2000s, technology, media and telecom (TMT) stocks were over-represented. (A number of them subsequently fell out of the indices). It was the same in 2007 with the banking and energy sectors.
Buying index stocks often means buying shares in companies which have already posted exceptional returns and which are trading at much higher valuations than those which have not been honoured with inclusion.
The arrival of indices was followed by the emergence of benchmarks. In the 1990s, pension funds and other institutionals started to give very precise instructions to the asset managers they had selected. Managers now had to comply with given tracking-error levels (or leeway vis-à-vis the index). The objective was crystal clear: limit any potential fund manager damage which might turn into a default. The advantage for fund managers was that this allowed them to easily quantify their personal contribution.
It may look like a win-win situation for both sides but the approach is also biased in that that fund manager must be careful about holding positions in stocks which are not index heavyweights. The trouble starts if the heavyweights start to rise as the fund manager will be forced to buy them to comply with tracking error limits. The dilemma hits value1 managers with over-strict constraints as they are forced to buy bubble stocks2 which they consider are outrageously overvalued. The end result is that some stocks become even more overvalued and bubbles start to form.
This is not a minor event as some might think. Benchmarking has had such a powerful impact on markets that it has modified the risk hierarchy observed empirically before this period (see the paragraph on ETFs for more). The more a fund is constrained by low tracking error, the more marked the phenomenon.
ETFS or trackers
The benchmark offensive resulted in people proving more receptive to the emergence of passive investing products in the 2000s. These vehicles allow investors to buy the entire index. They have been spectacularly successful and now account for 35% of global managed assets. But there are significant differences between markets, with passive investing representing 40% in the US and 30% in Europe.
ETFS have led to buy and sell décisions being based on the overall market trend
The approach has the major advantage of offering attractive prices and thus reducing investment costs. However, ETFs have led to buy and sell decisions not being based on a company’s characteristics but on the overall market trend. All equity positions are bought and sold at the same time. This means that a market with an increasing percentage of passive investing will see correlations between index stocks rise, actually causing a reduction in diversification! And markets are also much more vulnerable to a downturn.
At the same time, various surveys show that these “co-movements” also impact investors’ expected returns, which tend to coalesce, and liquidity risk, which tends to increase.
What about tomorrow?
Increasing trading volume is unrelated to an asset’s fundamental value. Most of these deals are in fact short-term trading. Our 19th century investors would be surprised at today’s brutal contraction in investment horizons, never mind the very short intervals between asset valuations. They would quite naturally wonder what purpose this all served.
We, the 21st century fund managers, would be delighted to advise them to stick with their healthy attitude to investing and to hold most of their (unconstrained) equity portfolios for some time, endeavouring to spot companies which are not unduly exposed to the hazards mentioned above. We would recommend them to be responsible, aware and active investors with a good grasp of each portfolio holding.
We would probably also tell them to have a look at new tools on today’s markets, trackers included, so as to diversify their investment approach. After all, a little momentum in an overall strategy is useful and also inexpensive.
Markets have taken all these developments on board and our industry has already changed. Benchmarking and tracking error are now less in vogue. Meanwhile, active investing is becoming, well, very active. But is not one of the aims of the budding alternative investment style precisely to break free of benchmarks?
At the same time, ESG (Environment, Social and Governance) themes, a less-constrained investment approach, has been a hot topic of debate in the last 10 years.
1 Investing in reasonably priced stocks
2 Share price levels that can no longer be justified by fundamentals
Chief Investment Officer
This analysis is an extract from the first House View published by Edmond de Rothschild.
This publication presents Edmond de Rothschild’s key convictions for macroeconomics, asset allocation strategy, and the principal asset classes.
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