Friday, December 29, 2017

A Real Risk: "Too Much Tech" - The Growing Peril Of Passive Investing

There are two steps in passive investing.
  • First, buy an index. Usually accomplished via an exchange traded fund.
  • Second, rebalance. 
It is easier to rebalance in an actively managed portfolio. For example in a 60/40 equity/debt account the rebalancing is done by selling off whichever component has grown past the allocation parameters and reinvesting in the component that hasn't kept up to bring the portfolio back to the chosen allocation.

There are levels of granularity the active manager can employ ranging from the time period between rebalancing to weightings of geographic or industry groups to enforce the discipline of buying whichever asset class is "cheaper".

In addition to forced "buy low, sell high" positioning there is the additional feature of avoiding gearing to the downside.
Let's say your 60/40 has grown so much on the equity side that stocks now comprise 80% of portfolio assets. Should a 50% decline strike. you are, to put it simply and without the math, losing that percentage from a greatly expanded base.
As my favorite Chinese translator (M.Sc.Eng, MBA) tells me when I blow something up: "No good."

A longer than usual intro for a shorter than usual piece at ZeroHedge, Dec. 28:
Too much of a good thing..." - That's the message that many passive investors are unknowingly dealing with as they approach the year-end.

In 2012, FANG Stocks (Facebook, Amazon, Netflix, and Google) accounted for less than 3% of the market cap of the S&P 500.
And, as WSJ reports, this is not limited to a small handful of stocks, it is worldwide - investors who loaded up on U.S. and Asian stock-index funds might be surprised to learn just what they own now: technology stocks - a lot of them.

Led by Apple Inc., Facebook Inc. and their peers, the weighing of technology stocks in the S&P 500 index has climbed to 23.8% as of Dec. 26, from 20.8% at the end of last year, according to S&P Dow Jones Indices.

Three years ago, tech stocks had a 19.7% weighting in the widely used U.S. stock market benchmark, which is currently tracked by funds with more than $2 trillion in assets.
Over the past 10 years, the weighting of the tech sector in the S&P 500 at year-end has averaged 19.6%.

The same is true in Asia, where surging tech stocks have powered sharp gains in Hong Kong, South Korea and other markets. The weighting of technology stocks in the MSCI Emerging Markets Index, whose components include Chinese e-commerce giants Tencent Holdings Ltd. and Alibaba Group Holding Ltd. , was 28% as of Dec. 21, from 23.3% a year ago.

“It’s sort of an inherent flaw of index funds,” said Kyle Moore, founder of Quarry Hill Advisors in St. Paul, Minn., referring to the way surging stocks have a bigger share of indexes that are market-value weighted, like the S&P 500.

Noting that some tech stocks have gained nearly 50% this year, Mr. Moore said a  typical investor response would be to trim exposure to those stocks and take profits. When that happens in an index fund, nothing happens automatically, he said....MORE