When Steve Morrow came across an online auction advertising the “urgent sale” of a hen for the poultry sum of NZ$1.50 (£0.78), he thought he’d found himself a bargain.
It wasn’t until he received a message from the seller asking exactly what he was planning to do with 1,000 chickens that he realised he’d clucked up.
Fortunately for Marrow (and the birds), the local community flocked to his aid and helped him to rehome all of the hens within a day.
Nevertheless, the incident serves as a helpful reminder of the importance of reading the small print and understanding exactly what you’re buying.
Investors flock to passive strategies
It’s a lesson that we as investors should bear in mind, as more and more assets are invested passively than ever before through both index funds and exchange-traded funds (ETFs). Over 40% of the US equity market is now held in passive funds. In 2005, that figure was just 5%.
It’s easy to see how passive strategies appeal to investors. Low fees and the market’s tendency to rise over time regardless of downturns are two of the main points of appeal.
As Jack Bogle, the founder of Vanguard and the father of index funds once said, “Don’t look for the needle in the haystack. Just buy the haystack.”
But the problem with buying the needle in the haystack is that you end up buying quite a lot of… hay.
Passive strategies don’t discriminate. When you buy an ETF, for example, you’re typically buying exposure to an entire index or a sector.
If you buy the S&P 500 UCITS ETF (VUSA), you’ll (surprise, surprise) have exposure to everything in the S&P500, in line with the market cap of every asset in that index. If Apple makes up 1% of the index, the ETF will hold 1% of its stocks in Apple.
Let’s imagine if Apple’s share price (and therefore market cap) grows dramatically and it comes to make up 2% of the index. If there are additional inflows into an index fund or ETF tracking the index, it will have to buy additional stock in Apple.
So if you’d happened to have bought, for example, the Wedbush Video Game Tech ETF, you’d have ended up exposed to the GameStop fiasco a couple of weeks ago.
Typically, the brick and mortar video game retailer has a weighting of around 4% in the ETF. At the end of January that ballooned to over 27%.
When an army of cocksure amateur investors were (supposedly) driving the GameStop share price to the moon, it hit a peak price of nearly $350, up from around $17 a few days before. I’m going to take a punt and assume that’s not an appealing entry price to you.
If an active investor – that is, someone who proactively picks and chooses which stocks and other assets to invest in – noticed that their GameStop shares were going through the roof, they’d probably sell them and take a healthy chunk of profit.
ETFs, and other passive investment strategies, can’t do that. They follow the market and buy additional shares at the current price if more investors buy into them.
That’s a good strategy when markets are working as they should, but it makes it more or less impossible to avoid buying into bubbles. If I’d bought shares in the Wedbush Video Game Tech ETF in the peak on 27 January, I could’ve bought it when it was trading as high as $114. Now, the ETF has slumped back down to $92.
Of course, GameStop is an unusual case.
But what about other stocks that many perceive to be in a bubble?
Let’s take Tesla, for example.
To many bears, Tesla is emblematic of the ongoing bubble in US tech.
But passive investing strategies, particularly ones that focus on tech or track the S&P 500, don’t just buy into bubbles, they can fuel them too.
Last year, when it was announced that Tesla would be added to the S&P 500 index, many active investors bought the company’s stock, anticipating that the inflows from index funds into the stock would drive up the share price. In turn, this drove up the share price further. Since the index is weighted by market cap, the higher Tesla’s share price, the more space it will take up in the index.
So by the time Tesla entered the index on 21 December 2020, its shares had already ballooned in value. Index funds and ETFs then bought the stock at a high, as they reweighted their own holdings of the S&P 500, pushing the price up even further.
In short, passive investing in the S&P 500 is fuelling the stock’s eye-watering valuations.
Of course, this works both ways. If there’s a sharp sell-off in Tesla’s stock, index-tracking funds and ETFs would follow, also selling off their holdings too and exacerbating the fall.
This is just one example. But an increasing number of analysts believe that passive inflows benefit the big names in the stock market the most.
Passive investing strategies will continue to appeal to many and I’d argue quite rightly. After all, they generally offer low costs, easy diversification and on average tend to outperform active managers as a whole.
But, as Mr Harrow learnt, cocksure investors should make sure they know what they’ll be exposed to when they buy, lest you fall fowl of a bubble.
All the best,
Research Analyst, Southbank Investment Research
PS Regardless of whether you use passive strategies or not, having a clear investment plan is important – particularly when markets are climbing to ever-more eye-watering valuations. Thankfully, Charlie Morris, editor of The Fleet Street Letter Wealth Builder, will be sharing his investment strategy for the year ahead – what he calls his “Money Map”.
Category: Market updates