The unintended consequences of passive investing

July 5, 2017

Investors in passive investment funds may find their investment is not as diversified as they thought, warns Rathbones' head of collective research Mona Shah.

Passive investors beware — there may be unintended consequences of tracking an index. If you are holding passive investment funds, you may be surprised to discover your actual exposure.

To take an example from the world’s largest market, the S&P 500 Index of US shares is home to the mighty FAAMG stocks (Facebook, Apple, Amazon, Microsoft and Google). They make up at least 13 per cent of the index, while the technology sector overall comprises 23 per cent. Any investors concerned about the valuations of these five stocks — as well as the broader technology sector — ought to be wary of investing passively.

But others may believe those names justify the high valuation. Indeed, our analysis shows the return on assets for the S&P 500 falls materially when we take out the tech names. This situation also reflects the high capital efficiency of technology businesses as well as their large cash balances.

A parallel can be drawn with the major index for continental Europe, the Euro Stoxx 50. Here the largest sector exposure is to financials at 21 per cent. Arguably this is the sector most weighed down by regulation, lower-quality assets and debt. Investors looking for quality companies should veer away from these and want to own some of Europe’s best brands, such as Unilever, Anheuser Busch (Budweiser), Siemens, Daimler, LVMH and L’Oréal.

Beware of the zombies

Japan's leading stock market index, the TOPIX, is compiled based on the tradeable volume of shares available. It has been criticised for favouring zombie companies or firms that prioritise full employment over and above creating shareholder value. Abenomics encouraged the creation of a new index based on return on equity, the Nikkei 400. It is more oriented towards small and mid caps and contains more consumer, financial and healthcare companies.

The difference between these two indices highlights how fund selection in passive investing is equally as important as in active investing. The new Japanese index is harder to track in a passive product because it is implicitly less liquid.

In fact, many investors are sceptical about allocating to Japan and may prefer to think of this market differently. For example, Japan is the market leader in robotics and the changing spending patterns of young consumers. However, it is difficult to get pure exposure to this theme in a passive way. We believe active managers are better placed to identify whether these trends are structural or cyclical and differentiate the winners from the losers.

A dash of EM with your China shares?

Investing passively in Asia and emerging markets can lead to unintended exposures due to the wide divergence of countries included in those indices. For example, the MSCI Emerging Markets index has a 26 per cent weighting to China. This index includes emerging Europe and Latin America where the economies are driven by different factors. We believe active managers can add value by choosing the fastest-growing countries and the stocks within them that have the most potential upside.

Looking at indices another way, it is curious that the US has a fairly heavy weighting in cyclically sensitive shares (excluding resources) and passive investors in the UK should note that a high proportion of the benchmark comes from resources at 22 per cent. However, the UK is a strange index as this is offset by a 37 per cent weighting in defensives, which tend to do better in economic downturns.

Japan, Europe and emerging markets also seem to be weighted towards cyclicals. To this end, investors looking for more defensive allocations should look beyond passive.

Our final point on investing using geographic indices is that the globalisation of business has rendered geographic stock listings irrelevant. Many companies, even small caps, can generate international growth relatively easily due to technology and trade agreements. For example, only 28 per cent of the UK equity market derives its revenue from the UK (see table below).

As investors, we see a clear need to look beyond indices in order to get the right mix of exposures and the best prospects for future returns.

Regional equity markets and their geographic revenue exposures

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