The rise in popularity of passive investing is astonishing to look at – net assets held by passive ETFs have grown 11x over the past 14 years, and investors continue to ship it in.
Although we stand behind our active style of management and preach active over passive for many of our clients, there are merits to these types of products. In fact, we sometimes leverage passive ETFs in our own strategies when we are looking to gain exposure to specific sectors.
Passive ETF products have undoubtedly made investing cheaper and easier for everyone. Unfortunately eating too much candy will give you cavities – there are currently 1,800 different US-based ETF strategies available to purchase, but there are only 5,300 publicly traded companies to put in them. Funds can only group these companies into so many combinations of ETFs before their underlying holdings begin overlapping. The result – today’s ETFs all kind of look the same (e.g. 568 different ETFs hold Facebook, and 601 hold Apple).
The continuous flow of capital into these ETFs, combined with a diminished pool of investable opportunities, is creating a crowding effect around a handful of large popular stocks and driving up their prices. In the S&P500, the top 1% of companies currently account for a staggering 16% of the entire index's market capitalization (Fig. 3). From a pure weightings standpoint, this is a level of overcrowding that we have not seen since the dot-com bubble.
What if it’s not because of overcrowding, and those select companies are simply what smart investors want to invest in at the moment?
Surprise, it’s not. The top 3 individual securities held by investment managers make up a cumulative portfolio weighting of around 6%. Contrast this with the three largest ETFs which hold the same 3 securities at more than double the weight, 12.2%.
With so much capital going into the same groups of names via ETFs, the broader stock market’s returns are now essentially correlated to the performance of a small handful of companies. Thus it doesn’t matter what products investors buy on the way up, they’re inadvertently buying those same stocks, and those stocks will drive the overall returns.
By the same logic though, when investor sentiment turns, it won’t matter what products they try to sell, they’ll all be trying to sell the same stocks.
Valuations in the US are high, especially after considering the slowing growth, and even viral, risks we face. After the strong run-up in Q4, it would be prudent for investors to reevaluate the level of concentration and risk they are realistically willing to take on. We recommend investors consider allocating away from some of the more crowded names where expectations are high, and into more defensive areas with long secular tailwinds.
It’s time to put the candy bar down for a bit and brush our teeth.