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The Pitfalls of Index Funds Demonstrated During Pandemic Selloff
In what has become an increase in warnings from news outlets like The Wall
Street Journal, another article was published yesterday unmasking and quantifying built-in negatives to index-based portfolio construction.
Hypothesis
– The Enormity of Index Fund Assets Presents Undue Risk
Last September, The Wall Street Journal published a widely discussed article titled “Index Funds Are the New Kings on Wall Street.” Within it, it was reported, “U.S.-focused index equity funds make up nearly 14% of the American stock market, up from roughly 7% in 2010, according to the Investment Company Institute. Index funds generally contribute up to 5% of U.S. stock-market trading, economists estimate.” The two primary warnings in that story were related to corporate governance and overvaluation of companies once added to an index. The fears were that there is too much power in too few hands and severe downside risk to owners during periods when investors quickly moved out of equities. From September to March, the percent and dollar amount invested in indexed mutual funds and indexed ETFs had grown. As of March 2020, $4.26 trillion sat invested in passive index funds. Up until now, there had not been conditions that tested the hypothesis. Data from the harsh market moves during the late Winter of 2020 are now available for people to evaluate the theory.
Yesterday’s WSJ article repeated this risk and also highlighted that any disruption or change in how people live could also impact the valuation of each industry sector within any large index. And, within each sector, every company could have amplified valuation shifts. The WSJ article referenced a new study of the economic shutdown and market sell-off that followed.
Evaluation
– 2020 Sell-off Provides a Test
The study, conducted by Jun Zhu, a portfolio manager at The Leuthold Group, asks, “Is Passive Ownership Exacerbating the Sell-off?” One of the main conclusions presented was that ‘Stocks with high passive ownership in the sectors with the greatest selling pressure underperformed.’ The underperformance detracted from the overall investment performance. Portfolio’s not bound by any index can be managed to instead match the current conditions. These portfolios are more nimble. For example, without the ability to lessen a portfolio’s exposure to energy, transportation, or hospitality as the pandemic grew was severely limiting and damaging. The same reasoning would hold that as the pandemic recedes, index funds do not allow a heavier exposure in these areas. In effect, Ms. Zhu was able to use the sell-off coinciding with the shutdown to empirically test the theories discussed in the September WSJ article.
The research analyzed data from the early weeks following February 19. She concluded those stocks most heavily owned by passive index funds and sector ETFs dropped more rapidly than the market as a whole. Even more compelling, she discovered they fell farther than similar companies not included in the large indexes.
Conclusion
– Supporting Data and Results
The performance study concluded stocks with the highest weightings within passive funds declined nearly three percent more than stocks not traded within an index (40.4% versus 37.5%). The study period was the 34 day period from February 19 through to March 23.
Ms. Zhu also found a correlation between sectors that attracted above-average levels of passive ownership and underperformance. Examples include financial, real estate, energy sector, and consumer-discretionary. The one industry that bucked this trend was healthcare, which dropped 30.3% during the freefall, compared with 60.7% for energy companies or 45.2% for the financial services sector.
It was discovered that index-heavy sectors were highly represented among the sectors that were hurt most. That is, in addition to broader indexes such as the S&P 500, sector investing, where there is also a high percentage of passive assets, showed the holdings were also among the big losers relative to their peers. The article quotes Zhu explaining, “It’s logical to say that sectors with highest passive ownership will fall more during a sell-off. My thinking is that it’s because ETFs will immediately sell when investors redeem assets; they don’t need to peek under the hood to decide which stocks to sell.” Overall the conclusion is that investing in an index fund is limiting and could be especially damaging during rapid declines.
Take-Away
Portfolio management that is focused on stock selection rather than index or index sector selection now has an advantage. Investing in companies instead, allows investors to pivot quickly. It is like the difference between a small boat changing course compared to a large ship. When the need to turn is sudden, the ship is less capable.
There is a growing undercurrent of discussion within investment circles of the negatives that come with massive pools of money all invested in the same stocks. The size itself is one of the greatest negatives as it produces overvaluation and has now demonstrated worse performance during a sell-off.
Change favors the most agile. Change is constant. Indexes and the funds that shadow them, by design, have no agility.
Suggested Reading:
Have Active Managers Received a Bum Rap?
Investment Barriers Once Seen as Insurmountable are Falling
Fast
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