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The dangers of being too passive

Investors may be in love with the 'magnificent seven' technology stocks, yet the top end of the stock market is notoriously volatile. That's worth noting for devotees of passive investing, says Orbis Investments.

2022 was the worst year for stocks since the global financial crisis, and the worst year for bonds in living memory. After the pain of 2022, it is comforting to believe that the hard times are over, and that a boom in artificial intelligence will drive the market higher, with investors rescued by the so-called “magnificent seven” US tech giants. Hope is seductive, but markets conspire to cause the greatest pain to the greatest number of investors. Today we see enormous scope for potential pain. Investors must adjust either their expectations or their portfolios.

A change of leadership

Today, it is difficult to imagine a market without the gargantuan growth of Apple, Microsoft, Alphabet, Amazon, and Meta. Yet over the past 30 years, only Microsoft has managed to stay among the world’s ten largest companies. If the past is a guide, the world’s most valuable companies will be a very different list ten years from now.

  • This is a unique problem for passive funds, which hold shares in proportion to their market capitalisation. That feature makes indexing a stealth momentum strategy – a huge benefit to passive investors through the persistent trending market of the last decade, but a danger when the trend reverses.

    In 2007, when Apple launched the first iPhone, its share price doubled. But the company was much smaller then. With a market cap of $75 billion and a weight of 0.3 per cent in the MSCI World Index, its huge share price gains contributed just 0.3 per cent to passive portfolios’ returns. In 2020, when Apple revolutionised the world by marginally improving the iPhone’s camera, its share price also doubled. But having started the year with a market cap of over $1 trillion and a weight of 3 per cent in the index, this time its rocketing share price added a full 3 per cent to the returns of index funds. The same is true in the other direction. When Exxon fell 20 per cent in 2015 with a 1.2 per cent weight in the Index, it hurt passive investors much more than when it fell 40 per cent in 2020 with a 0.3 per cent weight.

    As long as the trending continues, winners keep getting bigger and making greater contributions to index returns, while losers keep getting smaller and detracting less from passive returns. This benefit becomes a risk when trends reverse. Massive exposure to Japan was brutal at the start of 1990, as the Japanese market fell by more than half over the next two years. Massive exposure to tech was brutal in March 2000, as the Nasdaq fell over 70 per cent before bottoming. Massive exposure to Chinese state-owned companies looked clever in October 2007, but share prices fell as much as 75 per cent during the global financial crisis. They are still down 45 per cent from their peak today. 

    Markets are concentrated in recent winners

    The lesson from history is that passive exposure leads to concentrations in expensive areas just before those areas suffer. That is alarming if we consider how passive portfolios have evolved since the global financial crisis.

    In 2009, a passive investor in the MSCI World Index had a 50 per cent exposure to the US, 1/3 of their portfolio in the largest companies by market capitalisation, and a 10 per cent exposure to tech. Over the subsequent years, that portfolio has grown more American, more dominated by giants, and more tech heavy. Stock markets are now heavily concentrated in the US (70 per cent), giant companies (2/3rds), and in technology shares (25 per cent). The magnificent seven stocks (Nvidia, Meta Platforms, Amazon.com, Microsoft, Apple, Alphabet and Tesla) alone account for close to 20 per cent of global passive portfolios.

    A static investment strategy has not led to static exposures, but increased concentrations in the winners of the last decade. That has been rewarding for investors as momentum has persisted. But as 2022 showed, it carries risks. Each of those three areas (US, giants and tech) is more richly valued than its opposite. The US market trades at 22 times earnings, versus 14 times for shares elsewhere. Giant stocks trade at 20 times earnings, while the median global stocks trades at 17. Tech shares are valued at 30 times expected earnings, while other industries are valued at just 16 times in aggregate. Passive exposure to global stock markets has led to heavy concentrations in the most richly valued parts of the market.

    Investors are concentrated in recent winning styles

    That would be alarming enough, as close to 70 per cent of the assets in Australia’s 10 biggest retail global equity funds are in passive strategies*. But investors have also actively allocated to styles best suited to the day that is now approaching dusk. If we look just at the 10 biggest active retail global equity funds in Australia, 66 per cent of active assets are in growth strategies – those that generally pay higher prices for companies expected to grow more quickly. Only 10 per cent of assets are in value strategies.

    The trouble is what happens when the growth style falls out of favour. If investors hold multiple active funds to get diversification, but those active funds invest in very similar things, investors can end up being diversified in name only.

    Yet investors remain concentrated, with the bulk of their active assets in growth-style funds, and their passive assets concentrated in giant US technology shares. With valuations where they are today, that worries us. If they do not adjust their portfolios, they will need to adjust their expectations.

    *The 10 biggest retail global equity funds is based on retail unit trust size sourced from the 2022 Zenith Investment Partners International Shares Sector Report, November 2022. Passive is defined as those funds in index categories.

    Rob Perrone, Eric Marais & Shane Woldendorp

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