Market Thinking

making sense of the narrative

The Problem with Passive Equities

This is the second in a short series of posts which, as the title implies, address four important and inter-related problems for Wealth Management and, by extension, Asset Management and in conclusion offers a Solution.

In the first of this short series, we looked at the problem with Bond Markets and identified some structural issues, not least to do with the measurement and regulation of risk. The notion of a ‘risk-free rate’ was (mis)used in the wake of the Dot-com crash to imply that equities were much riskier than bonds, particularly when, incorrectly, combined with the short term volatility based Value at Risk (VaR) models intended for trading books rather than long-term investors. The net result was a structural push towards low yielding assets, a huge misallocation of capital and ultimately not only a ‘solution’ in terms of the Credit Default Swap market that actually caused a crisis in 2008 but now a situation where many bond portfolios are essentially a bar-bell of cash and high risk junk, with leverage and liquidity the key risks being taken but not being measured.

Passive Equities meanwhile have been widely touted as ‘the answer’ for long term investors on the basis that over time most active investors struggle to beat the index. However, they too suffer from a structural problem and, like bonds, this has also been caused by a mis-representation of risk – in this instance a focus on the benchmark at the expense of (almost) anything else. Without going into the passive versus active argument in too much detail here, we would instead make the point that the real problem today with Passive Equity investing is that the indices themselves have become poor representations of the broad economic exposure that underlines the concept of holding equities as part of a long term investment portfolio.

This problem is largely, although not entirely, a function of index composition and the widespread system of weighting by market capitalisation. As we noted in a recent post (options trading gives options for trading), the five largest stocks in the S&P500 currently make up almost a quarter of the total index weight by market capitalisation, a level not seen since the 1970s.

When you buy the S&P 500 index you are basically buying US Tech

To put it another way, a passive portfolio will have a holding in Apple that will be 10X that of Thermo Fisher, the 24th largest stock in the index. Is it likely to deliver 10x the risk adjusted return? And what about the other 476 stocks? The exposure of a passive investor to the underlying economics of these companies is so small as to be inconsequential. In effect, when you are buying the index, you are basically buying around half a dozen US tech stocks with a very concentrated stock and industry exposure. There is not a problem with this per se, so long as you are aware of the risks being taken to achieve those returns. Unfortunately nobody seems to be considering these as risks.

The biggest problem is that tracking the benchmark supposes that the benchmark represents a sensible portfolio

The reality is then that a passive exposure to the US via the S&P500 is really a concentrated exposure to the US tech giants of Apple, Google (Alphabet), Microsoft, Tesla ,Meta (facebook) and Nvidia. The largest non tech stocks are JP Morgan and Berkshire Hathaway, although between them they are still only slightly larger than Tesla. An exposure to the NASDAQ, while clearly a more conscious decision to focus on Tech, has a similar ‘Top Heavy’ skew and while the widespread claim that without the top 5 stocks the NASDAQ would be down 20% this year has been correctly disputed, it nevertheless makes a point. Look for example at the equal weighted and market cap weighted indices for the NASDAQ and the S&P500. While the S&P500 equal weight is actually flat on a one year view, it is down 12% on 5 years, while the NASDAQ equivalent is down almost 25%.

Market Cap weight been winning this year

On the one hand, one might ask why this isn’t a good idea? After all if the biggest stocks are always going to outperform the rest then why not have a portfolio heavily concentrated in a small number of tech stocks? The problem here of course is one of Portfolio Construction, that decision may be perfectly valid, but it is an really an active decision with associated risks, most obvious of which is the concentration risk, lack of diversification and simple mean reversion. Look for example at what happened to the equal weight versus market cap weighted indices in the aftermath of the dot com crash.

But watch out for mean reversal – a return of smart beta?

Indeed, the period after the DotCom crash not only saw a dramatic reversal of the equal weighted to market cap weighted indices, but also the growth of smart-beta as a concept. This took the notion that the market cap weighted benchmark was an inefficient portfolio and introduced a whole spectrum of different ways to ‘weight’ portfolios other than market cap. Given the power of the trend shown in the graph, almost everything ‘worked’, which was both good and bad, good for (mainly) hedge fund managers who had a Golden Era charging 2 and 20 for outperforming a market cap weighted benchmark, but bad in so far as there was no clear agreement on an alternative, leaving the majority of savings still tracking the S&P500 or the MSCI World, FTAll-Share or Stoxx. None of which are efficient portfolios for long term investors.

A US passive index for example has an exposure to internet/software/computers and semi conductors of around 37%. By contrast a European equivalent passive benchmark has, literally, one tenth of that, at 3.7%, the dominant components being Pharmaceuticals, Oil and Gas and banking. The situation is similar for the UK, except here mining is also a large component, which is really an exposure to Australia! As for the Australian market, this has 37% biased towards Banks and Mining, with the only real tech component being a 6.7% exposure to BioTech – itself almost entirely down to a single stock, CSL. As we say, none of this represent sensible investment portfolios.

Smart Beta did however, lead to an enormous number of new indices becoming available as benchmarks and more recently an equally enormous number of ETFs to track them. While these will be part of our solution to the problems we see in Asset Management, they are also causing some problems, as we will discuss in the next post when we look at the Problem for Active Equities.

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4 Replies to “The Problem with Passive Equities”

  • The very definition, whole point of, advantage and reason for truly passive equities investing is global market cap weighting. It is also the very definition of an efficient portfolio and the EMH, or at least the closest one can come to it in light of float issues and the impossibity to capture the return of private companies.
    Anything else, smart beta, equal weighting is an active investment and decision.
    Because in capitalism the sum of the winners (reinvested earnings) is larger than that of the losers over time and fund managers have been unable to do better than catching that difference sofar and will continue to be so.
    In truth, we have no idea whether Tesla alone or the Big5 will go bankrupt or go to 80% of world mkt cap over time. The only thing that matters is to catch that move, of either Tesla/the big5 or of those companies who replace them.
    And the only way to achieve that for sure is by investing in a global (not US) market cap weighted equity index product.

  • To be pedantic the Efficient Markets Hypothesis has nothing to do with market indices – it deals with whether all public information is reflected in market prices. The theory of efficient portfolios (or CAPM) is much narrower than most finance understand. There is assumed to be a gneral market index but there is nothing in the theory which requires this index to be the same for each investor. Consider people who are very concerned about climate change. They may decide to exclude all fossil fuel stocks from consideration for an investment portfolio. In their case the relevant market index should also exclude those stocks.
    It is a convenient but very misleading fiction to assume that a single market index will serve most or all investors. The choice of an index has to depend on the investor’s objectives, constraints and other circumstances. As the original article implies, all so-called passive investing is really a restricted form of active investing. That doesn’t weaken the case for investing in broad market indices rather than individual stocks which can rest on grounds of costs and other aspects of efficiency in portfolio management.
    I think that the “real” problem being highlighted by these blogs is that the dominance of the CAPM has led to the adoption of crass and very misleading ways of thinking about risk. Anyone aged in their 50s or 60s who is investing for retirement in an S&P index fund is taking a risk of a type and magnitude they are probably not aware of. They may not have the time, interest or skills to do any better but it is important that people like the present author point this out.

  • Thanks both for the comments. I guess one further point I would make is that while on the one hand, the portfolio is by definition ‘efficient’, it is very far from ‘effective’. As Steven Covey put it in the 7 habits of highly effective people, being efficient is knowing how to build a ladder, being effective is knowing which wall to put it up against! Hopefully the next few posts will expand upon this a little.

  • Surely the whole point to investment is to achieve a return on that investment that is in line with the expected return of the investor. The risk that matters is the risk of NOT achieving that expected return. Unless you can effectively forecast both the expected return and the risk to that expected return, you are not making an active decision – even if you claim to be doing so. The passive investor simply invests independently of any explicit forecast of expected return or the risks to it. Weighting a portfolio based on existing market cap doesn’t represent either a risk decision or an expected return decision. As a result, passive, global market cap weighting doesn’t represent an efficient portfolio in the sense of being an efficient investment portfolio. It may represent an efficient exposure portfolio – although that case is far from proven – but that is the equivalent of playing a fixer odds betting machine and expecting a percentage return to player above 100%.

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