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Since the financial crisis, passive investment vehicles have gradually gained dominance in global equity markets. In the early years of this decade, active funds had the upper hand. Today, there are more than 5,000 exchange traded funds (ETFs) on offer around the world, while active funds have struggled to raise investment. Recent research by JP Morgan found that around 60 per cent of equity assets are now accounted for by passive funds and quantitative funds, driven by computer algorithms. This compares with 30 per cent a decade ago.
Many of the larger ETFs and quant funds have driven investment flows that have ultimately benefited a few indexes such as the S&P500, NASDAQ or the FTSE100. At the same time, the prices of some of the largest blue chip stocks have benefited, both as index participants and as single stocks, and their values have increased significantly.
This is particularly pronounced among the big US tech stocks. Five of them – Facebook, Amazon, Apple, Microsoft and Alphabet (Google) – have added $600bn of market capitalisation this year, according to research from Goldman Sachs in June.
The result is that the indexes, which are weighted by the market cap of their constituent stocks, are increasingly skewed towards these stocks. A feedback loop has developed as investors, seeing these so called FAAMG stocks gathering value, invest in them (either directly or indirectly via an index / quant strategy ETF) even more, so boosting their value further.
Quant investors also follow this momentum, at the same time accelerating it. Moreover, central banks around the world, while keeping interest rates low and producing a glut of cheap investment capital, are themselves investing in such stocks. The Swiss National Bank, for example, is reported to have increased its investment in US equities to $80.4bn as of 31 March this year, compared to $26.7bn two years earlier.
All this means that the value of these equities is now divorced from the fundamentals of their companies’ performance. This gives rise to both risk and opportunity.
The risk is that blue chip equities, especially the well-known tech stocks, are massively overvalued. How much further they can go is a moot point. Given the all-time highs that the S&P500, the NASDAQ and FTSE100 have continually reached in recent months, it is questionable whether they can rise much more before investors start to bail out and take their profits.
There are several opportunities, however. If the big blue chips still have some way to run, then instead of buying indexes, which will mute their returns, there may still be mileage in riding them up as individual stocks, as far as is prudently possible (and also benefiting from the flow that may be seen when the indices and quant strategies are also bought as they will allocate to these stocks as well). But, further down the track, when the sell off begins, the values of ETF trackers based on the major equity indices are bound to decline and it may be that these FAAMG stocks sell off more due to their weightings. Once more it may be more optimal to short these stocks rather than the ETF itself.
Traditional, active asset managers have to accept some hard facts. First, ETFs and quant funds are here to stay. They command enormous investment capital, and they are cheap and easy to trade in and out of. When so many active managers fail to match major index benchmarks and charge clients much more than all-in ETF charges for the privilege, then they cannot expect to attract clients’ funds.
There has been regime change. Active managers need to understand the dominance of passive funds and accept the reality that big company stocks and major market indexes are now moved much more by them and much less by corporate fundamentals than they used to be.
However, there are opportunities created by the juggernauts of the ETF world that drive equity index prices. The main constituent blue chip stocks are likely to outperform their indexes, because they will also be chosen by other investors who buy individual stocks, or who buy sector-specific or smart beta indices that also include, for example, the FAAMG stocks.
By reading the equity market dynamics in this way, active managers can bring their clients good value, outperforming offerings based on passive strategies.
At Dolfin, we believe there are strong arguments in favour of both passive and active strategies. We offer active investment approaches and we have our own passive models. Importantly, our active and passive teams talk to each other to better understand the markets and identify the best investment opportunities for our clients. The debate about the value of passive versus active strategies misses the point in our view; both are valid and useful if deployed in the right way at the right time.