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Dearness of the index

By VW Staff. Originally published at ValueWalk.

Vltava Fundletter for the second quarter ended June 30, 2017; titled, “Indices And Index Investing.”

Dear shareholders,

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We are witnessing today a trend of investors massively moving their money from actively managed funds into passively managed funds, also known as index funds. The active-versus-passive debate is not new. It has been periodically recurring for decades, with each party alternating in dominance. Just now, it seems that passive investing is winning and the trend of shifting money into passive funds has in fact accelerated in recent years. What does this mean for us? Should we jump onto the bandwagon or should we instead take advantage of opportunities to which this trend gives rise? This letter is all about answering that question. Let’s begin by looking at some numbers. We will focus mostly on the US market, because that is where this trend has advanced furthest.

Money flows into index funds

Index funds endeavour to mirror the returns of a certain basket of equities or of an index. This is not at all a new product, but it has witnessed a real upsurge in recent years. According to Credit Suisse, the sum of money invested in US investment funds rose from USD 287 billion in 1989 to USD 8.7 trillion at the end of 2016. Over the same period, the volume of money in index funds increased from USD 3 billion to USD 2 trillion, and it doubled in just the past 4 years. In 1989, index funds accounted for approximately 1% of the market, but today they account for 23% of assets under management in investment funds. In the last ten years, USD 1.2 trillion flowed out of actively managed funds and USD 1.4 trillion flowed into index funds.

This unprecedented movement of money is deforming the market, changing its dynamics, and bringing both immense risks and opportunities. Before we get to those, let’s take a look at how indices are actually created.

How indices are created

We’ll take as an example a broad and most widely used index, the S&P 500. This is composed of the 500 leading US companies, which together represent approximately 80% of the entire US stock market. Individual companies are represented within the index in proportion to their market capitalisations. The largest weight goes to Apple, whose market cap is approximately USD 800 billion, whereas the smallest company in the index has a capitalisation of USD 2.7 billion. The ten largest companies account for 19.1% of the entire index.

Very important, however, is that the index’s composition is not permanent. Rather, it changes almost constantly. The weights of the individual companies in the index are continuously adjusted in accordance with changes in their market capitalisations. The more a share increases in price, the greater its weight within the index. A greater weight in the index means that more money flowing into the relevant index fund is directed to that stock. This brings us to the first important point: The more expensive a share is, the more money that flows into it. I call this the perverse cycle of index investing. When a share is rising in price, its weight within the index grows, which means more money passively invested into the index is allocated to it, which causes its price to rise even more, its weight in the index further increases, and thus it attracts even more money. The cycle is a closed one and feeds upon itself like some kind of perpetual motion machine. This simultaneously means that money tends to flow away from shares which are becoming steadily cheaper.

GM vs. Tesla

You will surely remember that at our last annual shareholders’ meeting we were discussing the valuation of two car manufacturing companies – GM and Tesla. At that time, they had approximately the same market capitalisation of USD 50 billion. We took a little survey then. An investor has USD 50 billion at his or her disposal and must choose whether to buy the entirety of GM or the entirety of Tesla. The investor who chooses GM can expect to obtain USD 9 billion in profit at the end of the year, whereas the investor who chooses Tesla will have to put in another USD 2 billion at the end of the year just to keep it alive. When we put it to a vote, there was no one who would have chosen Tesla and everyone voting sided with GM.

The “wisdom” driving the operation of index funds, however, keeps pushing GM’s share price down and Tesla’s share price up. GM achieves large profits, pays a big dividend, and is massively buying back its own shares for prices at around six times its annual earnings. This is decreasing the number of shares in circulation, its market capitalisation is not growing, and the weight of GM shares in the index is dropping. On the other hand, Tesla needs more and more money every year just to cover its losses and must repeatedly issue new shares. Because the market is so far ignoring Tesla’s inability to generate a single dollar in profit, not only does the share price keep increasing, but, due to the issues of new stock, its market capitalisation and weight in the index continue to grow at an even faster pace. Paradoxically, due to passive investing, at least on a relative basis, money flows away from shares of inexpensive and profitable companies and flows into shares of an expensive company constantly making losses. How many passive investors realise this?

Problem number one – dearness of the index

According to The Wall Street Journal, 41% of this year’s growth in the S&P 500 index is due to the rising prices of just five stocks: Facebook, Amazon, Apple, Google, and Microsoft. This simply results from the way indices work. The most money flows into the stocks of the largest companies regardless of how expensive they are. And they are indeed expensive. In one debate forum, Jan Dvo?ák recently asked an interesting question: what would be the PE of a single company combining Facebook, Amazon, Apple, Google, and Microsoft? I immediately set about to calculate this and came out with 30.6. That’s pretty high, isn’t it?

Some may object and insist these market leaders deserve this high valuation because they have a great future ahead of them. This may be true, but, to that point, I would like to recollect an article in Fortune from August 2000 headlined “Ten Stocks to Last the Decade”. These were the market leaders at that time: Nokia, Nortel, Enron, Oracle, Broadcom, Viacom, Univision, Charles Schwab, Morgan Stanley, and Genentech. Back then, it seemed that the future belonged to them and the fact that their stocks were expensive according to all reasonable measures was also disregarded. Over the following 12 years, these stocks lost 74.3% of their market value.

There is no idea in investing which would be good or bad under all circumstances, but the price of the investment is always crucial. And this is the main problem with today’s index

The post Dearness of the index appeared first on ValueWalk.

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